(March 6, 2009 – Washington, D.C.) — The 6th Annual Insurance Reform Summit presented by Networks Financial Institute at Indiana State University in Washington, D.C. on March 4th, assembled a full agenda of academic, policy and industry leaders, including an important panel that addressed the consumer impact that occurs when an insurance company fails. Panelists included Scott Harrington, PhD, Alan B. Miller Professor, Wharton School, University of Pennsylvania; Peter Gallanis, President, National Organization of Life and Health Insurance Guaranty Associations; and Roger Schmelzer, President, National Conference of Insurance Guaranty Funds.
Panelists provided their thoughts on consumer protection issues related to insurance company solvency and the kind of safety net there should be if insurance companies are regulated at the federal level.
Peter Gallanis, President of the National Organization of Life and Health Insurance Guaranty Funds, observed that until events in the fall 2008, there was comparatively little thought given to the implication of insurance insolvency. “There was no federal oar in the water when it came to insurance regulatory overview,” Mr. Gallanis noted. He added that the insurance sector has traditionally been a very conservatively operated segment of the financial services industry. “In 2008 many U.S. banks failed but no American consumer lost a penny due to their insurance company failing. The safety net system has done a solid job of protecting American consumers when companies fail,” Mr. Gallanis stated. He supported his point by describing the debacle involving Martin Frankel, who was convicted in 2002 of insurance fraud after a state regulator noted suspicious circumstances and tipped off authorities. Mr. Gallanis noted that policyholders did not lose money in the fraud due to the state guaranty associations immediately stepping in to protect policyholders. “There has really been no squeaky wheel; so insurance regulation has not received a lot of attention,” Mr. Gallanis noted.
According to Mr. Gallanis, the insurance industry addresses two types of solvency concerns: holding companies that own insurance subsidiaries; and the individual policyholders in the insurance companies themselves. He noted that it is critical to distinguish between the holding company and subsidiary firm when considering the need for regulation. “A subsidiary can be financially healthy even when the holding company fails,” he stated, noting that while AIG has experienced significant problems at the holding company level, most of its individual subsidiaries are operating without trouble. Gallanis added that state regulators have done a good job of regulating for solvency by creating receivership statutes that vary from state-to-state. The flexibility of the solvency model allows regulators in each state to place a distressed insurance firm in a category ranging from conservation to rehabilitation to, in the most serious incidents, liquidation. Even if an insurance company enters receivership, Mr. Gallanis noted that the claims of policyholder supersede all other claims and obligations presented by other creditors.
Roger Schmelzer, President, National Conference of Insurance Guaranty Funds, emphasized the inherent differences between the banking system’s FDIC coverage and the states’ insurance guaranty system. Mr. Schmelzer stated that whereas the FDIC is based on the need for immediate liquidity, the insurance guaranty system needs liquidity over time, and, only insofar as claims are made. He noted that the state guaranty funds were developed with the sole purpose of paying claims. “This just-in-time funding solution in the insurance industry is very different from the dollar-for-dollar approach used in banking,” he said. Noting that the system has worked very effectively, Mr. Schmelzer used the example of the nation’s largest insurance failure, Reliance Insurance Company in 2001. He stated that the $2.9 billion has been paid to fulfill policyholder claims, with $1.8 billion of that funding coming from Reliance assets and the balance paid by the state guaranty funds.
Scott Harrington, PhD, Alan B. Miller Professor, Wharton School, University of Pennsylvania, focused on economics, moral hazards and incentives within the insurance regulatory framework. Like Mr. Schmelzer, Dr. Harrington noted that sensible regulation should distinguish between insurance and banking when creating effective regulation.
He stated that government guarantees can create a moral hazard situation because system risk varies across financial institutions. He noted that the BASIL I and II banking structure is intricately linked with moral hazards.
Furthermore, he noted that systemic risk is qualitatively and quantitatively different between banks and insurance companies, especially in the property and casualty arena. Less risk in the insurance industry translates into less need for guarantees, he asserted, adding, “The evidence is overwhelming that there is a lot of market discipline in the insurance industry. Capital requirements can be – and are – more benign in the insurance sector.”
Referencing the paper presented by Therese Vaughan, Chief Executive Officer of the National Association of Insurance Commissioners, titled “Implications of Solvency II for U.S. Insurance Competitiveness and Regulatory Reform,” Dr. Harrington noted that the European Union’s movement toward BASIL II is fundamentally misguided and does not account for the inherent market discipline in the insurance sector.
Dr. Harrington cautioned against relying too heavily on model simulations in creating regulation. He noted that the sub-prime mortgage and foreclosure problems that arose following the housing bubble were not predicted by models and encouraged a heavy gamble that home prices would continue to appreciate. “The models failed. They were totally deficient,” he stated. He added that contributing factors to the collapse included a willingness for investors to gamble with other peoples’ money, the extremely low-cost financing available through Fannie and Freddie, and a deposit structure in the banking system that contributed to risky lending and expansion of subprime loans.
Harrington noted similar problems with the models used by AIG which did not account for collateral calls, the foreclosure crisis and other factors that negatively impacted the holding company. “AIG is not about insurance but about the liquidity crisis resulting from banking and securities events. [AIG] is a bank/security bailout, not an insurance bailout.” Dr. Harrington said.
He also considered the role of incentives, noting that state guaranty funds have demonstrated significant market discipline through their just-in-time funding structure. On the subject of an optional federal charter and systemic risk regulator, Dr. Harrington advocated against an expansion of federal guarantees for insurance company obligations. He noted that if a company is deemed systemically significant, it implicitly expands the definition of too big to fail, interfering with incentives and competition.
Networks Financial Institute at Indiana State University was founded in 2003 with a grant from Lilly Endowment. NFI strives to facilitate broad, collaborative thinking, dialogue and progress in the evolving financial services marketplace, concentrating on the areas of education, outreach and research. Headquartered in Indianapolis with offices in Washington, D.C. and on the campus of Indiana State, and with outreach internationally, NFI’s goal is to serve as a catalyst for change in the financial services industry.
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