The Future of Insurance Regulation in the United States

Insurance Regulation: The Need for Policy Reform

Beyond the push for increasing the federal role in insurance regulation, there is strong pressure for reforming insurance regulatory policies. Indeed, proponents of an optional federal charter (OFC) for insurance envision that federal officials would adopt policies that would significantly diverge from current state regulatory policies in a number of key areas. At the same time, the creation of an OFC would still leave an optional state framework in place, and the states would need to reconsider their regulatory policies in a new environment. Further, the constituency for improving insurance regulation extends beyond OFC proponents to segments of the industry that continue to support a state framework. Many economists also advocate significant changes in the way insurance is regulated . Hence the drumbeat for policy reform has been strong and growing for some time. Reform remains relevant regardless of how the institutional framework for insurance regulation evolves. This chapter discusses needed reform in U.S. insurance regulatory policies in critical areas. An assessment of insurance regulatory policies is valuable to guide both federal and state authorities as institutions change. We identify and evaluate the most significant policies in the principal areas of financial oversight, market regulation, and antitrust. Our evaluation considers the principles that should guide how insurance is regulated as well as the issues associated with specific Insurance Regulation: The Need for Policy Reform Martin F. Grace and Robert W. Klein 117 5 policy reforms and their implications. We also comment on the prospects for reform under several frameworks. Solvency Regulation The approach to overseeing the financial condition and risk of insurance companies should be foremost in any discussion of regulatory policies. This is an area of considerable concern, as the current U.S. system is outmoded and lagging behind the evolution of the industry and the systems employed or being developed in other jurisdictions, such as the European Union (EU).1 As noted in chapter 2, the states have applied a prescriptive, or rules-based, approach to regulating insurers’ financial condition, an approach that is heavily influenced by an accounting perspective . This approach is reflected in numerous laws, regulations, rules, and other measures that govern insurers’ financial structure and activities. Regulators tend to focus on insurers’ compliance with these rules rather than on how well they manage their financial risk. An accounting approach to solvency regulation focuses on the valuation of insurers’ assets and liabilities. It can be contrasted with a financial approach, which encompasses a comprehensive assessment of the risks that an insurer faces and looks forward in terms of its vulnerability to adverse developments that could cause it to encounter financial distress. This approach is typically associated with a dynamic financial analysis, which involves some form of scenario-based, or stochastic, modeling to evaluate an insurer’s financial risk. The emphasis on an accounting view rather than a financial risk view in U.S. regulation, as well as its prescriptive approach, affects insurers’ incentives and ability to manage their financial risk. It places certain constraints on an insurer’s financial structure that may or may not be warranted based on a more sophisticated assessment of its financial risk and how that risk is being managed. The U.S. approach also does not explicitly require or encourage insurers to manage their financial risk. There may be an assumption that if an insurer complies with all regulations that its risk is low, but there is no assurance that this is the case. Some U.S. insurers do perform internal risk modeling, but the regulatory system does not recognize or reward insurers for conducting this kind of analysis. The U.S. approach also affects U.S. insurers’ efficiency and their ability to compete in international insurance markets. It places constraints on insurers and com118 martin f. grace and robert w. klein 1. See for example Klein and Wang (2007) for an assessment and comparison of U.S. and EU insurance financial regulation. pels them to meet requirements that are not imposed on their foreign competitors . Further, over time, U.S. insurers may find it difficult to qualify for “regulatory equivalence” treatment in a foreign jurisdiction if the U.S. system is deemed inadequate or substandard relative to the system employed in that jurisdiction.2 There have been improvements in financial regulation in the United States (see chapter 2 and the following discussion). These changes have likely had some bene ficial...