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  • The Insurance Industry Is Risky. Federal Regulation May Be the Answer

    July 31, 2014 by Peter Coy

    (Article has been corrected to say that the Financial Stability Oversight Council, not the Treasury Department, designates financial institutions as systemically important.)

    Insurance in the U.S. is a big deal that’s regulated like a small deal. Insurance premiums paid each year equal about 7 percent of the U.S. gross domestic product, and companies such as American International Group (AIG) and Prudential Financial (PRU) rank among the biggest financial institutions in the country. Yet oversight of them and other insurers is fragmented among 50 states. Instead of a well-financed Federal Deposit Insurance Corp., policyholders of insurance companies that fail have no safety net except 50 state guaranty associations.

    Insurers have avoided federal regulation by arguing that their business is safe and sleepy. Only two insurers, AIG and Prudential, have been officially designated by the Financial Stability Oversight Council as systemically important financial institutions (MetLife (MET) is expected to join the roster). But the insurance business is changing. Insurers are becoming more bank-like in the sense that their liabilities (the money they raise from lenders and investors) are becoming more like bank deposits: short-term and unstable.

    To John Biggs, this is madness. Biggs, 78, earned a Ph.D. in economics while working full time as a college administrator. He chills out by reading Thucydides and Homer in ancient Greek. He got to know the insurance business as chairman and chief executive officer of Teachers Insurance and Annuity Association of America-College Retirement Equities Fund, better known as TIAA-CREF, from 1993 to 2002. Now he’s an executive in residence at New York University’s Stern School of Business and the co-editor with Stern economist Matthew Richardson of a new book, Modernizing Insurance Regulation.

    According to an analysis in the book by economists from the Federal Reserve Bank of Chicago, life insurance companies are relying more heavily on selling products such as guaranteed investment contracts and annuities, which investors can cash in immediately, making the companies more vulnerable to runs. The Chicago Fed researchers estimate that 54 percent of insurers’ funding is moderately to highly liquid (i.e., subject to withdrawal), up from 50 percent in 2007, before the crisis.

    If insurers lose their funding, they’d have to dump corporate bonds and other assets onto the market, driving up interest rates and possibly causing a panic. Property and casualty insurers could have trouble writing policies, squeezing customers such as airlines that can’t fly without liability coverage.

    We wanted to evaluate the world as it is, not as someone might wish it to be.”—Michael McRaith, director of the Federal Insurance Office

    The 2010 Dodd-Frank Act mostly left insurers alone, even though AIG, then the world’s largest insurance company, was one of the biggest flameouts of 2008. Dodd-Frank did set up a small Federal Insurance Office inside the Treasury Department and charged it with devising a plan for modernizing insurance regulation. In a report that came out last December, the office recommended a hybrid system that would increase federal oversight of insurance while leaving the states’ regulatory system largely intact. “We wanted to evaluate the world as it is,” says Michael McRaith, director of the Federal Insurance Office, “not as someone might wish it to be.”

    Biggs says the Federal Insurance Office report didn’t go far enough. The one chapter of Modernizing Insurance Regulation that Biggs wrote himself concerns an overlooked yet vital piece of the insurance market—the network of state guaranty associations, which are supposed to spring into action when an insurer becomes insolvent, protecting policyholders who live in their states. “This is my chance finally to write a piece on it,” Biggs says. “Nobody else in the industry has been interested in it.”

    While the guaranty associations, set up in the 1970s and ’80s, have smoothly processed small insurance failures, Biggs questions whether they could handle a big one. They played no role during the financial crisis when the Federal Reserve rescued AIG or when Hartford Financial Services (HIG) and Lincoln National (LNC) tapped the Troubled Asset Relief Program. (They have since repaid the money.)

    The state associations don’t maintain substantial reserves. To compensate policyholders of a failed insurer, they must send a bill to the insurance companies operating in the state. There’s a cap on how much can be recovered. And there’s no lender of last resort equivalent to the Fed: The state associations are barred from lending money to going concerns. Peter Gallanis, president of the National Organization of Life & Health Insurance Guaranty Associations, argues that the guaranty system replaces insurance policies with other policies, “and we don’t need a huge war chest to do that.” Biggs is skeptical. “There’s sort of a feeling that having a federal FDIC-type entity is such a radical and different step that we won’t take it,” he says. “I would say then, ‘Tell us how you’ll take us through the next crisis.’ ”

    Originally Posted at BloombergBusinessWeek on July 31, 2014 by Peter Coy.

    Categories: Industry Articles
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