How the insurance industry is saying goodbye to pragmatic regulation

As the title of this article infers, the nature of insurance regulation in the U.S. is changing and, in many respects, foreign agencies are becoming America’s regulators of financial institutions, including insurers. This has resulted in a wave of new regulatory requirements and proposals.

These regulations are dramatically different from those of the past – theoretical and not pragmatic. This is occurring without the direct input of state legislatures even though these requirements will dramatically change the state system of insurance regulation. State legislatures still have the ultimate power and authority of the nature of regulation in each state.

If this continues, it could result in a substantial change in the U.S. insurance markets, products and competitiveness all to the detriment of U.S. consumers.

I have had the good fortune and opportunity to be a very active participant along with many others in the development of insurance regulatory requirements from the early 1970’s to the mid-1990′s, when I left government service. Most of these propositions were enacted by the states. Observers have stated that those rules and requirements were at least in part responsible for the U.S. insurance industry not being adversely impacted by the financial crisis of 2007.

During the decades preceding the financial crisis, U.S. regulators changed and enhanced insurance regulatory requirements based on the learnings from insurers that became troubled and ultimately failed. Most often, new requirements were adopted by one or a few states before they were enacted by all states. This process allowed for testing to confirm cost vs. benefit of proposals and reveal other issues and problems. This practice is what I refer to as “pragmatic regulation.”

Pragmatic regulations are those that are based on practical considerations and address historical phenomena with reference to their causes and conditions. They emphasize practical results rather than theory, and the consequence of implementation is a known value. Furthermore, the compliance burden and cost thereof would not be greater than the benefit to be derived.

The risk based capital law instituted several years ago is but one example of a pragmatic requirement. Its primary objective was to establish a threshold capital level that, when penetrated, required regulators to respond.

This addressed the often-observed situation of regulators failing to act or act timely when an insurer’s financial condition was deteriorating. Sometimes existing regulation required modernization to meet current conditions and opportunities. The changes to the investment laws adopted several years ago are an illustration of this need. It permitted insurers to take advantage of investment strategies and opportunities under the controls set by the new law.

Theoretical regulation is, on the other hand, requirements that are conceptual or untested ideas or opinions. They do not result from practical experience that could produce a pragmatic response. The specific concerns they seek to address are not root causes, but a generalized notion that something must be done.

Largely, at the urging of non-U.S. government agencies supported by U.S. federal non-insurance regulators, state insurance regulators are moving toward theoretical regulation. I guess I should not find this surprising, since as far back as I can remember, non-U.S. regulators wanted federal regulation of insurers in the U.S. 

Simply, they could not understand the state system and wanted to deal with only the federal regulator. The International Monetary Fund continues to call for a U.S. system of regulating insurers that is less fragmented. Why state insurance regulators are willing to relinquish the U.S. system that has worked so well is a mystery. 

The NAIC and its members should be touting the U.S. regulatory system, which has permitted a marketplace that fosters competition on price and terms and stimulates innovation. This system has permitted the insurance industry to grow financially and contribute substantially to the U.S. economy. A competitive system will produce an occasional failure, so the regulators’ task is to detect them early on and remove them from the marketplace when rehabilitation is not feasible. 

As Edwin Patterson wrote in his 1929 seminal insurance administrative law textbook, the preliminary focus of insurance regulation is the ability to pay claims or to regulate for solvency. That objective guided insurance regulation, not only then, but in the decades that followed.

One example of theoretical regulation is the Own Risk & Solvency Assessment (ORSA) requirement that is currently being adopted by several states. The origin of this regulation is clearly Solvency II requirements applicable to European insurers. At its essence, ORSA takes a management tool – enterprise risk management (ERM) – and converts it into a regulatory requirement.  

ERM goals and objectives are not solvency based, but are aimed at achieving strategic goals and identification of risks to an insurer’s business plan. These are important to managing a company, but what regulators will do with this new information is not clear. 

In fact, the inability of regulators to give specific guidelines for ORSA reports due this year may confirm this concern. I raise this issue because the power and authority of an insurance commissioner is based on present conditions and not those that may arise in the future. Nevertheless, at a recent NAIC meeting a highly vocal regulator stated, “I really do not think we will see a large insolvency in this country for a long time because of ORSA.”

This same regulator had previously referred to ORSA as a game changer. I concur with the declaration since it shifts regulation from pragmatic to theoretical. However, over the last 50 years, I have learned there is no “silver bullet” for improving regulation.