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[Senate Hearing 109-1067]
[From the U.S. Government Publishing Office]

                                                       S. Hrg. 109-1067
 
                  PERSPECTIVES ON INSURANCE REGULATION 

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                                   ON

             EXAMINING THE INSURANCE MARKET AND MODERNIZING
                          INSURANCE REGULATION

                               __________

                             JULY 18, 2006

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html

                               ----------
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Washington, DC 20402-0001 

            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                         Andrew Olmem, Counsel

                          Jim Johnson, Counsel

              Stephen R. Kroll, Democratic Special Counsel

                 Dean V. Shahinian, Democratic Counsel

                 Lynsey Graham Rea, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)

                            C O N T E N T S

                              ----------                              

                         TUESDAY, JULY 18, 2006

                                                                   Page

Opening statement of Senator Allard..............................     1

Opening statements, comments, or prepared statements of:
    Senator Johnson..............................................     7

                               WITNESSES

Randal K. Quarles, Under Secretary for Domestic Finance, 
  Department of the Treasury.....................................     2
    Prepared statement...........................................    31
Scott E. Harrington, Ph.D., Alan B. Miller Professor, The Wharton 
  School, University of Pennsylvania.............................    16
    Prepared statement...........................................    37
Robert W. Klein, Ph.D., Director of the Center for Risk 
  Management and Insurance Research, Georgia State University....    18
    Prepared statement...........................................    43

                                 (iii)

                  PERSPECTIVES ON INSURANCE REGULATION

                              ----------                              

                         TUESDAY, JULY 18, 2006

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 2:05 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Wayne Allard, presiding.

           OPENING STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. The Committee will come to order.
    Today, the Committee will examine perspectives on insurance 
regulation, a topic which will likely be one of our biggest 
issues for the coming year. Insurance has helps millions of 
people during some of the most vulnerable times in their lives. 
Insurance has served many people well. Even for those who do 
not personally own an insurance policy, every American has a 
vested interest in a robust, well-regulated insurance market.
    Well-regulated insurance markets help families and 
businesses manage risk. If private insurance were to fail in 
this function it would likely fall to the Government to provide 
assistance. Because insurance is so important, it is critical 
to maintain healthy insurance markets through good regulation. 
Therefore, we cannot take reform of insurance regulation 
lightly. It is important that we understand the implications 
for States, and especially for consumers.
    Before coming to Washington, D.C., I served in the Colorado 
State Senate. My service as a State legislator gave me a 
particular appreciation for States' rights. However, I 
understand the insurance markets have evolved, and so market 
regulation must also evolve to keep pace.
    Before we can make decisions about the future of the 
insurance industry we must understand the present state of the 
industry. Quite simply, we need to understand and define the 
problem to be solved before we start discussing solutions. This 
hearing will be an important step in that effort.
    Today, the Committee will continue its examination of 
insurance regulation by hearing the perspectives of three 
experts on financial regulation.
    I would like to welcome back to the Committee Under 
Secretary Quarles, who has a unique background in financial 
regulation having served in a variety of positions with 
responsibilities for financial regulation at the Treasury 
Department during the current and prior Bush Administrations. 
In addition, he served as co-head of the financial institutions 
group at the law firm of Davis, Polk and Wardwell.
    I am also pleased to welcome to the Committee Dr. Scott 
Harrington and Dr. Robert Klein, two of the country's leading 
experts on insurance regulation.
    Before we enact any insurance regulation reforms, 
especially any of the comprehensive reforms that have been 
proposed, it is crucial that all of the economic and legal 
consequences of such reform be fully understood. Accordingly, I 
look forward to hearing the experts' insights of our 
distinguished witnesses. I want to thank all of the witnesses 
for being here today. Their testimony will be very helpful.
    At this time I would like to submit an opening statement by 
Chairman Shelby for the record. If the Chairman shows up this 
afternoon--he might--then we will give him an opportunity to 
make some comments.
    Senator Sununu. I do not have an opening statement, Mr. 
Chairman. I am ready to go right to the witness.
    Senator Allard. Very good.
    Then as other members show up that may have statements, we 
will give them an opportunity to present those statements.
    We will start with the first panel. Secretary Quarles, 
welcome to the Committee, Under Secretary of Domestic Finance, 
Department of the Treasury. We look forward to hearing your 
comments.

 STATEMENT OF RANDAL K. QUARLES, UNDER SECRETARY FOR DOMESTIC 
              FINANCE, DEPARTMENT OF THE TREASURY

    Mr. Quarles. Thank you. Thank you, Mr. Chairman, members of 
the Committee. It is a very welcome opportunity to appear here 
today to discuss both the role of insurance in our economy and 
the need to modernize the regulation of insurance.
    As you noted in your opening comments, in the first 
instance, the issues surrounding insurance regulation are 
significant because the insurance industry is a significant 
part of the U.S. financial sector. It has assets of over $5.6 
trillion at the end of 2005.
    But even more importantly, insurance, like other financial 
services, has significant ripple effects through our entire 
economy. The ability of individuals and businesses to insure 
against risk adds certainty to their planning. That contributes 
to greater economic activity, enhanced economic growth. And 
insurance is also, like other financial services, in that its 
cost and its safety and its ability to innovate and compete are 
heavily affected by both the substance and the structure of its 
system of regulation.
    So, as a result, not only of the industry's importance 
considered simply as a separate line of economic activity, but 
even more as a result of its consequences for commerce and 
economic growth more broadly, we should seek to ensure that the 
regulatory system for the insurance industry is consistent with 
the efficient and cost-effective delivery of its services, and 
with continuing innovation in the design of its products.
    Now in that regard there seems to be virtually no 
disagreement that the current insurance regulatory system is in 
need of modernization. As you know, unlike the banking and 
securities sectors, insurance is solely regulated at the State 
level. While this multiplicity of regulators can provide 
certain benefits in the form of local expertise and control, it 
does raise a number of issues that deserve further 
consideration. In our view, those issues fall into three main 
categories.
    One, potential economic inefficiency. That results both 
from the substance of regulation, especially, and form control, 
but also from the structure of regulation, the inevitable 
duplication in cost that is associated with multiple, non-
uniform regulatory regimes.
    Second, our international impediments.
    Both questions of comity, facilitating international firms' 
operations in the United States which benefits U.S. consumers, 
and competitiveness, facilitating U.S. firms' operations 
abroad, which provides growth opportunities for those firms, 
helps diversify their risk exposures.
    And third, systemic blind spots. The inability of the 
official sector to understand and respond to the insurance 
industry's evolving contribution to risk that affect the 
financial system as a whole.
    So, at the most fundamental level, the question in each of 
these areas is whether the benefits from regulatory competition 
that are fostered by our existing multiple regulatory structure 
or could be fostered by other multiple regulatory structures, 
are outweighed by the costs of regulatory fragmentation, which 
are significant in a 50-State system. And in light of that 
consideration, where needed, what can be done to address those 
issues.
    Now, I discuss each of those three categories of issues in 
detail in my written testimony, but let me just provide a brief 
overview of them here.
    First, with respect to economic inefficiency. One aspect of 
modernization has been a focus on the lack of uniformity in 
State regulation. While the NAIC has achieved some success over 
the past 135 years in fostering more uniformity among the 
States, many of its model laws and regulations have not been 
enacted, and differing State insurance regulatory treatment can 
lead to inefficiencies and to undue regulatory burden. In turn, 
that can directly limit the ability of insurers to compete 
across State boundaries, and reduced competition can diminish 
the quality of services, it diminishes consumer choice, and 
ultimately leads to higher prices.
    Now among the areas of potential inefficiency from non-
uniform regulation are licensing, and form approval 
requirements. I describe those in some detail, again, in my 
written testimony. But perhaps the greatest potential for 
inefficiency in the current system is with price controls. 
Insurance is maybe the last major market in the United States 
with direct price controls. And the term price controls is 
frequently used to describe the State regulation of rates that 
are used by property and casualty insurers that are licensed or 
admitted in a State.
    One of the fundamental principles that we are all familiar 
with is that price controls result in inefficient outcomes. If 
the mandated price is set above the market clearing price, the 
result will be surpluses. If the mandated price is set below 
the market-clearing price, the result will be shortages.
    The latter outcome is what we generally observe in 
insurance markets with strict price controls. When insurers are 
not able to charge what they feel is an adequate rate for their 
product, they generally tighten their underwriting standards in 
order to limit their writings to preferred risks that are less 
likely to suffer an insured loss. This obviously leads to 
shortages in the voluntary market and increases demand on what 
is referred to as the residual markets, which are State-
sponsored mechanisms that provide consumers with another way to 
obtain automobile, property, or workers' compensation insurance 
coverage.
    Insurers that operate in a State and provide insurance in 
the voluntary market in the State are generally required to 
participate in these residual markets. But as the size of the 
residual market grows, in light of the price control, it is 
likely that fewer and fewer insurers would be willing to do 
business in that line of insurance in the State in question.
    That puts further pressure on the residual market 
mechanism. States usually respond by adjusting prices to 
preserve the viability of that particular market. As a result, 
States with a less restrictive regulatory environment are 
generally characterized by lower and less volatile loss ratios, 
smaller residual markets, and insurance expenditures that are 
below the national average.
    Next, let us turn to the international impediments. U.S. 
firms and firms from abroad in insurance and in banking and in 
the securities sector compete around the globe, around the 
clock. Clearly, foreign sources of capital are important if we 
are going to have a robust U.S. insurance market.
    But as noted above, the lack of uniformity in our State-
based insurance system has the potential to lead to 
inefficiency, undue regulatory burden. And while that burden 
and inefficiency affects all insurance companies that are 
licensed to operate in the United States, foreign firms are 
likely to find adapting to such standards more difficult.
    In my prior role as the Assistant Secretary for 
International Affairs at the Treasury I led our financial 
regulatory dialogue with the European Union and with other of 
our bilateral partners. Among the issues that were stressed, 
again, both in our E.U. dialogue and in others of our financial 
regulatory discussions with foreign officials were rate and 
form approvals, capital adequacy standards, guaranty fund 
membership, and most fundamentally, that our insurance market 
has at least 50 different regulators, and the insurance 
companies have no single regulator to coordinate with on 
insurance matters.
    Navigating the existing regulatory structure is daunting 
for a new foreign company that is seeking to do business in the 
United States. And it has certainly impeded the flow of capital 
into the United States to some degree.
    Finally, there is the question of systemic blind spots. As 
previously noted, the insurance sector is a critical part of 
the broader U.S. economy, and in terms of size alone is a key 
participant in the U.S. financial sector. In comparison to 
other financial institutions, it could be argued that financial 
problems at an insurer pose less potential to generate broad 
economic problems as opposed to systemic risk to the financial 
system.
    But nonetheless, there remains some potential for 
disruptions in the insurance market to affect economic activity 
in financial markets. And most importantly, these potential 
risks, whatever the degree of them may be, may not be well 
understood at the State or the Federal level in our current 
structure.
    For example, there has been a considerable amount attention 
paid to the expanding credit derivatives market. While in that 
area there are a number of issues that might warrant attention, 
as with many other derivative contracts, a credit derivative is 
very similar to an insurance policy that pays off when certain 
credit events occur. So given the close correlation to 
insurance, insurance companies appear to be taking a more 
active role in this market.
    From an overall perspective of market stability, do we 
fully understand what risk insurance companies are undertaking, 
or how their activity could affect the credit derivatives in 
other financial markets?
    While the State-based system has made improvements in 
solvency and holding company regulation, under a structure with 
over 50 different regulators it may be somewhat difficult for 
individual State regulators to get a firm handle on the risks 
that large, complex insurance companies pose to our Nation's 
insurance system. Add into that mix that the Federal Government 
has little to no role in the current regulatory system and we 
are left with what could be a large blind spot in evaluating 
risks that are posed to the general economy and to financial 
markets.
    So, to sum up, it is clear to us, we think it is to most 
observers, that our current system of insurance regulation 
requires modernization to meet our current challenges. The 
existing system of regulation has the potential to lead to 
inefficient economic outcomes. That raises the costs and 
reduces the supply of insurance products to consumers. It 
deters international participation in our domestic markets. 
Again, that raises costs and limits consumer choice. It creates 
obstacles to our own insurance firms' international expansion, 
and it limits the ability of any one regulator to have an 
overview of risk in the insurance sector and its contribution 
to risk in the financial system more broadly.
    These are issues of importance not just to the insurance 
industry or even to the larger financial services industry, but 
to the economy as a whole because of the essential role that 
the mitigation of risk through insurance has in promoting 
commercial activity and enhancing economic growth.
    We have been monitoring the developments with respect to 
insurance regulation closely, and while we are still evaluating 
what approach we believe to be the most appropriate, it is 
clear that all of the approaches that are on the table should 
be assessed in light of the fundamental principles we have 
discussed today, and we are looking forward to continuing this 
discussion.
    Thank you, Mr. Chairman.
    Senator Allard. Thank you very much for your testimony.
    We will now proceed to the first round of questions. We 
will set aside 5 minutes for each member to ask questions.
    I would like to start this off by asking a few questions. 
First of all, while the role of insurance at the Federal level 
has been rather limited, there has been a Federal role, and it 
has been dispersed among several agencies. Should an optional 
Federal charter be created? Do you believe that the new 
regulator should be independent or should they be part of an 
existing agency? What are your thoughts about that?
    Mr. Quarles. Well, that is an issue that I think requires 
further consideration. We at the Treasury Department would not 
have a final view on that. Both regulatory structures exist 
currently and are shown to work. The banking regulatory bureaus 
that are part of the Department of the Treasury, the OCC, and 
the OTS, the depository insurance regulatory bureaus, obviously 
work well and have for a long time. So that is a model that 
certainly can work.
    The independent regulatory model is also one that has been 
shown to work over time. In the very near term it would be the 
case that if the choice were made to stand up a new Federal 
regulator, in the transition period that would be easier to do 
within an existing bureaucracy and with the support of an 
existing bureaucracy than to immediately stand up a new 
regulator. That could ease the time to implementation.
    But for a final view, we do not have a final view at this 
time.
    Senator Allard. And if we were to go to an independent 
regulator, would you think that would need to be supported by 
fees provided by the insurance industry?
    Mr. Quarles. That has, in general, become a principle of an 
independent regulator, is that its administrative expenses are 
generally provided by fees on the regulated industry. But 
again, I think that is an issue that needs to be considered in 
light of all of the full range of issues that are relevant to 
both the type of regulator that would be put in place and to 
the best structure of regulation that would ultimately address 
the issues that I outlined in my testimony.
    Senator Allard. Now, if it went into an agency, would you 
expect that agency to absorb those costs, or do you expect the 
industry to pay for it?
    Mr. Quarles. Again, that is not a question on which we have 
a final view. But again, the usual structure of an independent 
regulatory agency is that it assesses fees in order to cover 
its costs.
    Senator Allard. Now, Mr. Secretary, in your written 
testimony you noted that the European Union has undertaken 
reforms to forge one insurance market for all 25 of its member 
states in the E.U. If the Europeans are successful in 
establishing a unified insurance market do you visualize any 
adverse consequences for the U.S. insurance market and/or the 
competitiveness of U.S. insurance companies?
    Mr. Quarles. Well, I do think that the structure of 
regulation, particularly for financial services companies has a 
significant impact on the competitiveness of the regulated 
industry. So as the regulation of an industry in another 
jurisdiction becomes more streamlined and efficient, one would 
expect that to result in increased competitiveness for the 
affected industry, and at the margin result in a competitive 
advantage for that industry versus the United States.
    Senator Allard. Now, we have a decentralized regulatory 
regime right now basically right now with the States. Is there 
an adverse impact, from your point of view, on the global 
market and how the insurance companies can compete?
    Mr. Quarles. The existing issues largely result from 
questions of reciprocity when a domestic insurer wants to 
operate abroad, and frequently the regulatory structure abroad 
requires the jurisdiction in which they want to operate to have 
a point of contact, to have confidence in a single, regulatory 
interlocutor in the home jurisdiction of the financial services 
company, in this case an insurance company that would be 
operating abroad. So, that is a current issue.
    More broadly, I think there is a concern that if, over 
time, insurance companies that become used to operating under 
more streamlined regulatory jurisdictions abroad come to view 
our current regulatory structure as too much of a barrier to 
trade, that further barriers could be imposed on our financial 
services companies wanting to operate in their jurisdictions.
    Senator Allard. OK. My time is expired.
    First individual in on the opposite side is Senator 
Johnson.

                STATEMENT OF SENATOR TIM JOHNSON

    Senator Johnson. Well, thank you, Mr. Chairman. I regret 
that I was delayed. As you know, this hearing is overlapping 
caucuses and it complicated some things, but I appreciate--what 
I thought I would do is, I want to make a statement and then I 
want to ask Under Secretary Quarles a question at the 
conclusion of that.
    I do appreciate holding this hearing on a continuing effort 
to examine the issue of insurance regulatory reform. Last week 
we heard from 10 witnesses representing various segments of the 
insurance industry, and the general sentiment expressed was 
that it is time for the Federal Government to act. And I agree.
    Senator Sununu and I have done just that. We have crafted a 
comprehensive legislative proposal that would give insurers a 
choice of charter.
    Insurance is the last sector of the financial services 
industry for which there is no concurrent State and Federal 
regulation, but it appears that the climate is changing. With 
the proliferation of the Internet, the world is becoming 
smaller and smaller while the national and global marketplaces 
are becoming larger. Consumers today have more information 
available to them than ever before. Virtually instant access to 
information, allowing them to comparison shop for products and 
services all over the world.
    Businesses have to be able to meet consumer needs and 
expectations. Insurance is no exception. It is a large, complex 
and diverse industry and its growth should not be hindered by a 
regulatory structure that has failed to adequately adapt to the 
evolving business environment and consumer demands. This 
process is about reforming a system of regulation that has 
failed to keep pace.
    What was once a sector of the economy that was marked by a 
local geographic focus, the financial services industry has 
taken on a national, and even a global focus. And as a part of 
that industry, insurance cannot and should not be left behind. 
Not everyone is convinced that we need to create a dual system 
of regulation like we have for the securities industry or the 
banking industry. Some argue that consumers will be confused by 
having to deal with more than one regulator.
    I have to echo the sentiments expressed by my colleague, 
Senator Sununu, last week. Consumers are not dumb. And quite 
frankly, many consumers right now hold policies that are 
governed by more than one regulator, as do many Members of 
Congress who maintain residences in different States.
    Under an optional Federal charter, my local agent in South 
Dakota, who wrote the policy on the home my wife, Barbara, and 
I own, could obtain a national license and also be able to take 
care of my insurance needs here in Washington.
    As a consumer, it has never occurred to me that I have 
insurance policies that are governed by the laws of different 
States, and I have never had a reason to call Merle Scheiber, 
South Dakota's Director of Insurance because of an issue that 
my agent or insurance company could not assist me with.
    What has occurred to me is that because I own property in 
different States, I have to do business with different agents 
licensed in those different States. And for that I have no 
choice.
    However, S. 2509, the National Insurance Act, would give me 
that choice as a consumer, and would give my agent a choice, as 
well.
    I am also disappointed that opponents of Federal 
legislation have suggested that the Federal Government is 
incapable of protecting the interests of consumers, and that 
Washington is full of inexperienced, insensitive and 
unresponsive bureaucrats who would make a mess of insurance 
regulation and consumer protection. I just could not disagree 
more.
    We have created systems of Federal regulation here in 
Washington that are widely referred to as world class. A 
Federal insurance regulator would be no less. I expect the 
commissioner of national insurance to be an expert on the 
issues facing the industry and develop strong consumer 
protections and regulations that are applied and enforced in a 
fair and impartial manner.
    I want to be clear. A Federal regulatory agency should not 
be expected to be a close friend of the industry, nor should 
the industry or agents expect to have its ear. That would be a 
recipe for disaster.
    Mr. Chairman, I look forward to hearing from our witnesses 
today. I have appreciated the testimony of Under Secretary 
Quarles. These witnesses are highly credentialed experts, and I 
appreciate their willingness to appear before us today.
    To Under Secretary Quarles, some people believe that the 
Federal Government does a pretty bad job of protecting 
consumers or responding to their needs. How would you respond 
to the contention that a Federal regulator would be distant and 
that a State-based regulation of insurance assures a level of 
responsiveness that simply cannot be matched at the Federal 
level?
    Mr. Quarles. Well, I think that whether a regulator is 
going to be responsive or not is not a function of the level of 
our governmental structure that we place that regulator at, but 
the charge that we give that regulator and resources and 
attitude of that regulator.
    We have certainly seen that the Federal Government can do a 
very good job of consumer protection. So I do not think that it 
is inherent in the nature of the Federal/State dichotomy that 
the Federal Government cannot do a good job of consumer 
protection.
    Senator Johnson. Do you believe the presence of a Federal 
insurance regulator would threaten the survival or 
effectiveness of the State system?
    Mr. Quarles. I do not think that would be a necessary 
consequence. In answering this question, I do want to 
underscore that as we look at the various proposals on the 
table at the Treasury Department we have not yet come to a view 
as to what we think is the right approach. But it is definitely 
not an inevitable consequence of creating a Federal option that 
saps the vitality of the State system.
    I mean, that is the attractiveness of one regulatory system 
versus another, is going to be a function, again, of the 
attitudes of the State regulators and their approach to their 
regulatory responsibilities.
    Senator Johnson. I realize my time is about expired. Let me 
ask just one last point here.
    Do you see evidence of competitive inequities between 
banks, security firms, and insurance companies because of their 
differences of regulation?
    Mr. Quarles. As bank securities firms and insurance 
companies do increasingly become competitors in areas of--in 
offering certain financial products, I think that it is the 
case that the current fragmented regulatory system does create 
some obstacles for insurance companies in the time to market of 
new products. And it is in the new products area that this 
competition would largely be occurring.
    So while I do not want to overstate the importance of that 
differential for the insurance industry, the burden that that 
places, I think that it is undeniable that there is a greater 
time to market for a new product in the insurance industry than 
in banking and securities.
    Senator Johnson. Thank you, Mr. Secretary, and I yield 
back.
    Senator Allard. Let me now call on the Senator from New 
Hampshire.
    Senator Sununu. Thank you, Mr. Chairman.
    Mr. Secretary, you talked a little bit about price controls 
in your testimony and I think you indicated that you felt that 
was perhaps the greatest factor or contributor to inefficiency 
in the current State-based system.
    Roughly how many States still have some form of rate 
regulation or price controls?
    Mr. Quarles. It is a very significant majority. I think it 
is about 43.
    Senator Sununu. Do you believe that consumers fare better 
in States or under a system that does not regulate rates?
    And if so, how so?
    Mr. Quarles. No. I think that the, you begin with the fact 
that--just look at average insurance expenditures in the States 
that have less regulation. The States with less price 
regulation do not have insurance expenditures that are any 
higher than the States with more price regulation. In fact, the 
States with the least price regulation actually have insurance 
expenditures that are below the national average.
    So, what would the reasons----
    Senator Sununu. And that is something that has been 
correlated?
    Mr. Quarles. Yes. Absolutely. And when you look at what 
would be the reasons for that, a State like Illinois, that has 
relatively little rate regulation would, in fact, have 
relatively low insurance expenditures.
    And that is because of the operation of these residual 
markets and the effect of price controls on the availability of 
insurance that I described in my testimony.
    When there is a price control that sets the price below 
what would be the clearing price, then the insurer is going to 
withdraw the supply of that product in that State. As it 
withdraws the supply, the residual market mechanism would 
require all insurers who were offering that line of insurance 
in the State to participate in the residual market.
    Senator Sununu. I want you to explain that in a little bit 
more detailed fashion, how those residual markets work and why 
it is problematic for price controls, why it is problematic for 
their usage to be increased in the price control situation you 
described.
    Mr. Quarles. Sure. Absolutely. So, given the recognition of 
the fact that if you require an insurance company to provide 
its product at a certain price, it will choose not to provide 
that to certain customers because it will judge the risk too 
great for the price that it is allowed to charge.
    Most States that have these price controls then have a 
residual market in which the insurers are required to 
participate for individuals who would seek automobile insurance 
or worker's comp insurance that they would otherwise be unable 
to obtain in the admitted market or in the voluntary market.
    And if you offer a particular line of insurance in the 
voluntary market, you are generally required to participate in 
this residual market.
    But while, in theory, you could come to the same effect by 
pricing the residual market appropriately, in order to 
compensate the participants in the residual market for the 
extra risk they are taking for insuring these greater risks, 
that is very, very difficult to do as a matter of practice.
    So what you will almost, therefore, always see is that the 
residual market risk is underpriced. And if it is significantly 
enough underpriced, you will have insurers saying well, if I 
offer this line of insurance at all in this State, even in the 
voluntary market, I am going to have to lose money in the 
residual market. And so I need to withdraw from that line 
entirely in that State.
    In order to prevent that from happening, the rate 
regulators will then seek to adjust the price that is allowed 
in these two markets, increase the price in order to make this 
a continuing attractive economic proposition for the insurance 
companies. But the effect of that is to result in average 
prices that are either higher because of the inefficiency of 
trying to set prices this way, or certainly no lower than would 
be created simply by allowing the market to operate.
    Senator Sununu. You suggest that the residual markets are, 
more often than not, they are not self-sufficient. So where 
does the money come from required to cover their operating 
costs?
    Mr. Quarles. Insurance companies are assessed to cover the 
deficiencies of the residual market, which is another reason 
that there is an economic disincentive for them to continue in 
the activity that requires them to participate in that residual 
market.
    Senator Sununu. What is the long-term effect on price 
controls on volatility, price volatility?
    Mr. Quarles. Well, as I mentioned, when a rate regulator 
sees that this effect is happening, it will attempt to adjust 
the rates in order to make the market attractive. But because 
this is not being set by the market because it is being set in 
a centrally planned environment, those rate changes, when they 
happen, are likely to be significant swings.
    And therefore, the volatility of rates, it is not just the 
level of rates that is lower in the less regulated States, but 
the volatility is significantly lower in the less regulated 
States.
    Senator Sununu. One more question about price controls, and 
then I will come back, because my time is up.
    I read a description of--I think it was referred to as 
price trapping in the market that suggests that another 
unintended consequence of a price control is it makes insurers 
less likely to lower their rate, even if their costs go down, 
because of the fear--and I guess it is a natural fear, human 
behavior--that they would not be able to raise them because 
they are in a regulated environment. That for political 
reasons, although it is hard to imagine any regulator ever 
operating in a political way--and we have had some very good 
ones testify in front of this Committee. But maybe for 
political reasons people would be reluctant to approve a later 
rate increase.
    And so they would therefore not want to lower the prices 
even if their own cost profile showed that they could do that 
and still make money.
    Is that real or did I just make it up?
    Mr. Quarles. I do not have statistics for you today as to 
how common an effect that is, but inevitably that disincentive 
is there because rate regulation, in any environment, whether 
we are talking about insurance or financial services more 
broadly, or other areas where there is rate regulation, rate 
regulation is also often very sticky on the upside.
    Senator Sununu. Thank you very much. Thank you, Mr. 
Chairman.
    Senator Allard. I will now call on the Senator from Rhode 
Island.
    Senator Reed. Thank you very much, Mr. Chairman. Thank you, 
Mr. Secretary.
    Let me follow up on the line of questions Senator Sununu 
raised about residual markets. Looking ahead, if there was a 
Federal charter, then a company could go in under their Federal 
charter into a State and not participate in the residual 
market, which is mandated in the State law. Is that a fair 
assumption?
    Mr. Quarles. Well, it would depend on the specific 
structure that was created, but in general that would likely be 
the case with the Federal charter.
    Senator Reed. And there could be then either an unintended 
incentive to get out of the residual market, which you 
described, some complications or problems with the Federal 
charter, leaving the residual market diminished consistently, 
causing those that stayed to pay increasingly higher prices to 
cover the risk.
    And the point of the residual market is to provide 
protections to consumers that cannot get it in the voluntary 
market. Is that correct?
    Mr. Quarles. Yes. That is right. That would be a logical 
consequence.
    Senator Reed. But that would be, in some respects, a very 
unfortunate consequence because you would diminish 
opportunities to purchase insurance or you would shift the 
burden onto those companies for one reason or another who 
cannot get out of the State regime; is that correct?
    Mr. Quarles. I think that--I mean, the issues that you are 
describing are definitely issues that would need to be 
considered, the incentives that would be created for movement 
between regulatory regimes. I do not think that movement 
between regulatory regimes, whatever the incentives that were 
created, would be particularly rapid because of just the legal 
and technological obstacles there are to move between 
regulatory regimes.
    But the issues that you are describing would definitely 
have to be considered.
    Senator Reed. This raises a general question. I wonder if 
Treasury has looked ahead at some modeling or projecting the 
dynamics of what would take place with these two charters. Have 
you done that, Mr. Secretary?
    Mr. Quarles. No. We have not.
    Senator Reed. Would you consider that to be a useful 
exercise?
    Mr. Quarles. Absolutely. I mean, as this dialogue 
continues, it is the sort of thing that we would need to look 
at.
    Senator Reed. One of the areas for concern, and I think you 
addressed this in the context of the European experience versus 
the United States is they are trying to streamline their 
procedures, streamline costs, become more efficient. Some of 
those costs, though, go to consumer protections.
    And there is a fear, I think again, if we look ahead, that 
if you have a very stripped down Federal approach, without some 
of the protections that you have at the State level, that it is 
inherently more attractive from a profit and loss standpoint, 
you will get people moving over there and you will have 
consumer protections that are weakened.
    Is that a concern we should have?
    Mr. Quarles. I think that should be less of a concern when 
you are considering the options of a Federal charter or not. 
Again, without wanting to take a view here at all, because we 
think that all of the various structures that have been 
proposed approach these issues in different ways and merit 
consideration.
    But I do not think that there would be, in any--I neither 
think that it is inherently necessary nor likely that a Federal 
regulator, even if it was streamlining the costs of consumer 
protection, would do a worse job of consumer protection.
    Senator Reed. Well, one would hope that you are right. And 
it is our responsibility to make sure of that if we go down 
this path.
    Again your comment, it would seem to me then that if we 
assume that consumer protections will be adequate and similar 
to the States, we still have the issue of the residual market. 
But the great attractiveness of this approach is avoiding the 
registration costs and the--supervisory costs, rather, in 50-
plus jurisdictions versus one. Is that the biggest?
    Mr. Quarles. The registration costs, as well as form 
approval burdens. I mean, the general multiple administrative 
burden. On the economic inefficiency, regulatory burden side, I 
think that is important, although I do not think that the 
regulatory burden on the industry is the most important reason 
for considering the modernization of our current regulatory 
structure.
    I think issues like the international impediments and the 
systemic blind spots that I have described are at least as 
important as the regulatory burden.
    Senator Reed. Thank you. Thank you, Mr. Chairman.
    Senator Allard. OK, we have finished the first round of 
questioning.
    Senator Sununu. Can I just ask a couple of more questions 
of the Secretary?
    Senator Allard. That is what I am going to propose to the 
Committee. I think we have got time to do a second round if we 
limit it to 3 minutes. Is that satisfactory to the members? OK, 
we will go to the second round and we will limit it to 3 
minutes per person.
    On regulating financial entities, it requires a great deal 
of resources and expertise. And a successful regulator must be 
able to attract and retain top caliber employees. And, in some 
situations, it has been difficult for Federal financial 
regulators to get adequate human capital.
    In fact, nearly all Federal regulators are able to pay 
above the general Government pay scale because of the demand 
out there in the labor market.
    Do you believe that States have the resources and experts 
necessary to carry out the necessary level of oversight of 
these large and highly complex entities?
    Mr. Quarles. Well, I certainly do not want to characterize 
all States or any particular State, but it would obviously be 
true that there is significant variation in the resources that 
States devote, and are able to devote, to insurance regulation.
    Some States, obviously, devote a lot of resources and 
relatively sophisticated resources to it. They are able to do 
that. But others are not. And I think that is an issue, the 
significant variability of the resources.
    Senator Allard. In insurance, we have companies that may 
specialize in certain areas. You may have casualty and property 
companies. You may have life insurance companies. You may have 
automobile insurance, title insurance, medical liability, 
medical insurance.
    What area do you think most necessitates a Federal 
regulator?
    Mr. Quarles. As we look at the issues, I do not think that 
I would prioritize across lines at this moment. I mean, the 
broad categories of issues that I described at the outset of my 
testimony, whether it is regulatory burden, international 
impediments, systemic overview, are applicable really across 
each of those lines to one degree or another.
    So as we think about the issues right now, we have not 
prioritized which are most in need of regulatory reform. We 
think that it is applicable, really, across them all.
    Senator Allard. In my State of Colorado, in some insurance, 
we get put into a regional pool. So the insurance company just 
does not look at the State, but also looks at other States that 
might be part of this pool. For example, in some, we are a part 
of California, which we accuse that of creating a high-premium 
rate for people in Colorado.
    Do you think that a Federal regulator would have an impact 
on these regional pools?
    Mr. Quarles. I think it is certainly easier for a Federal 
regulator to consider issues across State boundaries. Issues 
that effect State-to-State relationships.
    Senator Allard. My time is expired. I might want to pursue 
that a little further later on.
    The Senator from South Dakota.
    Senator Johnson. Mr. Secretary, is there anything 
especially unique about the business of insurance, of the 
insurance industry, that would make an optional Federal charter 
or concurrent State and Federal regulation inappropriate or 
inoperable?
    Mr. Quarles. No. I do not think so. I think that, while 
there are, obviously, a number of unique aspects of the 
insurance industry versus other elements of the financial 
services industry. I do not think that any of them relate as to 
whether a Federal regulator would affect the question--whether 
a Federal regulator is appropriate.
    I think whether or not one concludes that that is the right 
way to address the issues we have described here will depend on 
other considerations and not on the special nature of 
insurance.
    Senator Johnson. Given the fact that Congress has been 
confronted with a number of insurance issues over the past few 
years that have been national in scope, such as TRIA, and large 
scale devastation, such as we experienced with Hurricane 
Katrina, do you believe that a Federal regulatory presence of 
some sort on some insurance matters is needed?
    Mr. Quarles. I think that has been a weakness in the 
overall Federal Government regulatory structure. And again, 
without wanting to describe how one should address it, we do 
find that there is a weakness in our ability to analyze and 
address insurance issues, generally.
    Senator Johnson. I yield back.
    Senator Allard. Senator from New Hampshire.
    Senator Sununu. You indicated, in your testimony, that 
foreign capital is important to the insurance market, and that, 
to some degree, perhaps the State regulatory structure can 
impede that flow. Could you describe a little bit the role that 
the foreign capital plays in our domestic insurance markets? 
And in what ways in particular could the regulatory system be 
improved to help sustain a better flow of foreign capital?
    Mr. Quarles. Well, the role that foreign capital plays in 
our insurance markets--which is beneficial--is the role that it 
plays in our economy generally, but particularly in financial 
services.
    There are very sophisticated foreign financial services 
firms that are capable of providing useful competition in the 
industry as a whole, which is always beneficial to consumers.
    They can provide additional product innovation. There are a 
number of ways in which foreign financial firms, particularly 
from other developed countries--I am thinking particularly of 
Europe--can bring benefits to our financial services sector 
through participation.
    But it is not nearly anecdotal. I mean, we hear a lot of 
anecdotes from foreign insurance firms that they find our 
insurance regulatory system enough of a barrier that, at the 
margin, they are less likely to make investments in our 
insurance industry and to operate in our direct insurance 
industry in the United States, which is the most heavily 
regulated.
    And you can see that simply by looking at just the general 
level in foreign participation in different financial services. 
In the banking area, for example, over a very long period, 
foreign participation in the banking industry has been 20 to 25 
percent of the industry as a whole. In direct insurance in the 
United States, it is significantly less, maybe about 15 percent 
of premiums for direct insurance in 2005 were written by 
foreign-controlled firms.
    Senator Sununu. Assuming for the sake of discussion that 
Senator Johnson and I have persuaded 98 of our colleagues to 
support our legislation, and 435 members of the House of 
Representatives and it is on the verge of becoming law because 
the President is prepared to sign the legislation, having 
received that recommendation from his top policy advisors at 
Treasury, would you suggest or prefer that a regulatory agency 
for life and property and casualty be independent with Treasury 
or an entity that stood by itself outside of Treasury?
    Mr. Quarles. That is interesting. So, the question that you 
are asking is it better for a regulatory agency to be 
independent within Treasury, as opposed to just within 
Treasury.
    Senator Sununu. Yes. I think we can assume that is going to 
be an independent thinking regulatory body, but should it be 
within Treasury or outside?
    Mr. Quarles. Well, that is an interesting question. I do 
not want to give you a final view on the specific question with 
respect to insurance today, because it is not one that we have 
completely formulated?
    Senator Sununu. So you are refusing to answer my question?
    [Laughter.]
    Senator Sununu. It has happened before.
    Mr. Quarles. I promised that I would never do that. But, as 
a general rule, I do think that, just as a general matter of 
organizational behavior, if you will, it is something of an 
issue when an entity is within an organization that, in fact, 
has no control over it, but then is expected to have some 
responsibility for it.
    And I do not know, again, that that structure is, in fact, 
is necessary for the efficient operation of a regulator. But 
those would be, I think, some of the principles that we would 
have in mind as we looked at that proposal.
    Senator Sununu. Thank you.
    Senator Allard. Thank you, Senator Sununu. I did not 
realize that you were such an idealist that first question 
implied.
    Senator Sununu. Well, it is all hypothetical.
    Senator Allard. Well, we have completed the first round. I 
would just remind the members of the Committee that the 
Committee asked for questions to be submitted within the week, 
and then we ask the participants on the panel to respond back 
in 10 days. I hope that, Mr. Secretary, you would be willing to 
do that. And thank you for coming and testifying before the 
Committee.
    Mr. Quarles. Thank you, sir.
    Senator Allard. We will now go to our second panel. And on 
our second panel, we have Dr. Scott Harrington, who is the Alan 
B. Miller professor at the Wharton School, University of 
Pennsylvania.
    He is joined by Dr. Robert Klein, Director of the Center 
for Risk Management and Insurance Research at Georgia State 
University.
    And when you gentlemen get settled, we will start off with 
testimony first from Dr. Harrington, and then we will go to 
you, Dr. Klein. And you are familiar with the rules, I think, 
that ask for 5-minute testimony. We will not be real strict on 
that enforcement, but at least reasonably close, if you would, 
please.

STATEMENT OF SCOTT HARRINGTON, Ph.D., ALAN B. MILLER PROFESSOR, 
               THE WHARTON SCHOOL, UNIVERSITY OF
                          PENNSYLVANIA

    Mr. Harrington. Good afternoon, Mr. Chairman, and members 
of the Committee.
    Much of my research over the past 30 years, for better or 
for worse, has focused on the economics of insurance markets 
and insurance regulation.
    A number of my publications have dealt specifically with 
whether problems in insurance markets and insurance regulation 
justified some form of optional Federal chartering. And, at the 
time, given my assessment, I concluded ``no.''
    In February of this year, I prepared an issues paper on 
possible Federal chartering of insurance companies and other 
Federal intervention for the Networks Financial Institute.
    Despite some reforms, I highlighted that regulations of 
rate classification and policy forms remain dysfunctional in 
many States. With no end in sight, and with burdens on 
interstate commerce, cross-sector competition, and cross-
national competition, I concluded that some form of Federal 
intervention was necessary to modernize insurance regulation.
    When not impeded by misguided regulation, most modern 
insurance markets are highly competitive. Regulations should 
focus on reducing the extent to which some insurers might 
misrepresent or fail to keep their promises. It should do this 
through appropriate monitoring of insurance solvency and some 
oversight of sales and claims practices.
    The main features of State regulation and solvency are 
entirely sensible. The system of limited ex post assessment of 
solvent insurers to pay a portion of failed insurers' 
obligations is appropriate economically, and it works 
reasonably well, especially under some circumstances. Limits on 
State-guaranteed protection reduce their adverse effects on 
policyholders incentives to deal with safe insurers.
    Compared with pre-funding, such as occurs under deposit 
insurance, ex post assessment likely increases financially 
strong insurers' incentives to be vigilant in pressing for 
effective solvency regulation.
    But other aspects of State regulation fail to pass a cost 
benefit test. Lack of uniformity, unnecessary or excessively 
burdensome processes for form approval represent a major 
problem. They disadvantage insurers compared with federally 
regulated financial institutions and something really needs to 
be done to help speed to market.
    Price controls are truly problematic. State requirements 
that regulators approve rates before use for many types of 
insurance are unnecessary and counterproductive.
    Prior approval regulation of insurance rates produces 
significant administration and compliance costs borne by 
consumers.
    It cannot and does not affect insurance company profits in 
the long run. It impedes timely adjustments of rates to new 
information. It produces fewer but larger rate changes, greater 
swings in coverage availability in residual market size, and it 
increases insurers' risk.
    Quite a bit of my research over the years has documented 
these effects. In addition, some States significantly restrict 
underwriting and rate classification, including caps on 
residual market rates.
    Some of these policies provide some benefit. But, in 
general, they create cross-subsidies from lower-risk buyers of 
insurance to higher-risk buyers. They push up average premium 
rates in a State to a more high-risk insurer and fewer to low-
risk insurers, or they buy less coverage.
    And these types of subsidies to high risk reduce higher-
risk buyers' incentives to take action to mitigate risk.
    In some cases they require costly State re-insurance or 
risk adjustment mechanisms to insure stable markets with all 
sorts of distorting influences.
    Appropriately designed, optional Federal chartering and 
regulation of insurance has the potential to achieve the 
essential goals of regulatory modernization, to increase 
uniformity, to provide national certification or approval of 
policy forms, to have rates and rate classes determined by 
competition, rather than rate regulation, and streamline or 
lower the cost of monitoring market conduct.
    And it can do this all, with luck, while preserving or even 
enhancing private market incentives for safe and sound 
insurance markets. It will motivate States to further modernize 
and it could promote beneficial regulatory competition over the 
long run.
    Requiring federally charted insurers to participate in the 
State guarantee fund system, perhaps with minimum standards, is 
a sensible approach in any optional Federal chartering.
    It should be recognized, however, the guarantees of 
insurers' obligations under Federal chartering could evolve 
toward nationalization over time, with uniform coverage. And 
with some Federal oversight of State-chartered insurer's 
insolvency, as is true in the dual banking system.
    Any optional Federal chartering system will entail some 
risk that the scope of Government guarantees of insurers' 
obligations will ultimately increase, including being backed by 
the full faith and credit of the United States, reducing 
private incentives for safety and soundness.
    A fundamental goal should be to avoid expanding guaranteed 
fund protection under any optional Federal chartering system, 
and impossible to intelligently narrow the scope of guarantees 
to encourage private incentives for safety.
    A pre-funded Federal guarantee system should likewise be 
avoided. Federal-chartered insurers' rates should not be 
subject to prior approval regulation. In turn, that would help 
discipline regulation of State-chartered insurers' rates. There 
are, again, inherent uncertainties, both about the specifics in 
any legislation that could ultimately be adopted, and whether 
any initial exemptions for freedom for price controls would 
persist over time.
    With regard to residual markets, it is not part of any 
unnecessary optional Federal chartering plan that Federal-
chartered insurers' would not have to participate in residual 
market.
    But what is important is that if they participate in 
residual markets that there are some sort of safeguards, at 
least written safeguards, that would discourage extensive cost 
subsidies at the State level through the residual market 
mechanism.
    Optional Federal chartering could be an effective engine 
for modernization. There are risks, and it would involve the 
cost of creating a new Federal regulator. Unintended 
consequences or mistaken policies would have national 
repercussions.
    There are other approaches. One would be narrow and 
carefully targeted preemption of certain State regulations that 
do not meet minimum standards.
    And a second would authorize insurers to choose a primary 
State for regulation and operate nationwide, in large part, 
under the rules of that State. I think both of those types of 
approaches are also worthy of serious consideration.
    Thank you.
    Senator Allard. Dr. Klein.

STATEMENT OF ROBERT W. KLEIN, Ph.D., DIRECTOR OF THE CENTER FOR 
                 RISK MANAGEMENT AND INSURANCE 
               RESEARCH, GEORGIA STATE UNIVERSITY

    Mr. Klein. Good afternoon, members of the Committee that 
are left, or will be here. I appreciate the opportunity to 
speak to you today about insurance regulation.
    I am going to try to keep my comments relatively short, but 
obviously, I am going to be open to questions. My views on the 
issue of what kind of regulatory reforms are needed are 
probably pretty close to Scott Harrington's. My views on the 
institutional route to those reforms lie somewhere between the 
optional Federal chartering proponents and the optional 
chartering opponents.
    So, at the end of my testimony, I am likely to have made 
more enemies and less friends, and probably just about 
everybody will hate me. But that is not untypical for me to do.
    Senator Allard. Welcome to the academic world.
    Mr. Klein. I am sorry?
    Senator Allard. Welcome to the academic world.
    Mr. Klein. Right. I will just briefly mention, in 30 years 
I have been an insurance regulator, and I have worked for 
insurance regulators. And, during the last 10 years, I have 
been an academic studying insurance regulators. So, that is 
what I have been doing.
    I am going to quote a bit from my written testimony, and 
then I am going to do a little ad hoc summarization.
    In my opinion, the States have come a long way in improving 
their regulation of insurance, but further reforms are needed, 
both in terms of the States' structures and processes, as well 
as their policies.
    I think the preferred institutional route to this goal is 
strong Federal standards for and oversight of States' 
regulation of insurance that will move their structures and 
policies to where they need to be.
    In essence, the States need to appropriately and 
efficiently regulate things that need to be regulated, and not 
regulate things that do not need to be regulated.
    However, if this cannot be achieved under the institutional 
arrangement that I would prefer, then an optional Federal 
charter approach may be necessary to achieve the objectives the 
States would be either unwilling or unable to achieve.
    The specific reforms that I propose reflect four basic 
themes or characteristics.
    One, the elimination of regulation where it is not needed.
    Two, uniform and appropriate and efficient regulation where 
it is needed, to the extent that uniformity is possible, given 
differences in State laws that cannot be changed.
    Three, singular institutions and processes for insurers' 
filings and applications that would be approved for all States.
    And four, full rationalization and coordination of all 
State enforcement and compliance activities.
    In the regulatory system that I envision, the States would 
efficiently enforce a uniform set of regulations, to the extent 
that uniformity is legally feasible in their respective 
jurisdictions and the inefficiencies and costs of unnecessary 
State differences and redundant regulatory processes would be 
minimized.
    I have prepared a list of 11 reforms which I will list or 
summarize.
    First of all, there should be a uniform set of requirements 
for insurance products sold to persons, small businesses, and 
for mandated insurance coverages, to the extent that the 
uniformity is legally feasible.
    So, we would have requirements, but they would be uniform 
among all States.
    Regulatory restrictions or mandates on insurance products 
sold to medium and large businesses should be eliminated, 
except where Government requirements or significant 
externalities compel such regulation.
    Prospective price regulation should be eliminated in all 
lines of insurance except those lines where market failures and 
abuses have been demonstrated, such as title insurance and 
credit insurance.
    Some residual authority to intervene in pricing should be 
retained should competition and market forces fail to ensure 
fair and competitive rates.
    A process should be established that would allow an insurer 
to make one product filing that could be approved for sale in 
multiple States, as well as one licensing application that 
could apply to multiple States.
    A rigorous set of uniform financial standards should be 
established, maintained and properly enforced. We are almost 
there but we have more ground to cover.
    Also, the laws and process for administering insurance 
company receiverships need to be further rationalized and made 
uniform among the States.
    There should be streamlined and appropriate State 
enforcement of all insurance regulations that are retained or 
instituted, including single, national, financial and market 
conduct examinations that would serve all States.
    Efforts to streamline and nationalize the licensing and 
regulation of insurance producers should continue to their 
maximum possible fulfillment.
    I will just briefly summarize the rest of my points.
    We do need to look at systems for the reporting of various 
insurers' data, beyond that which you would call financial 
data. That is an area we need to look at.
    I would basically do away with elected insurance 
commissioners. I would have them all appointed.
    I do think that there should be a further strengthened 
program of consumer public education and information. I think 
that, despite all of the efforts that we have to get consumers 
more informed, there is a huge amount of ignorance out there, 
which is a problem. So we need to be more aggressive and 
proactive in that area.
    And finally, if we establish the type of institutional 
framework that I described, we are going to need some kind of 
comprehensive and continuing evaluation of that structure. So 
that, basically, we have a certain amount of Federal monitoring 
and oversight to make sure that the States are doing what they 
are supposed to be doing, and that the system that has been 
established and designed functions as it is supposed to 
function.
    So, those are essentially my recommendations, and I will 
leave it at that. And I will be happy to answer any of the 
questions that you may have.
    Senator Allard. Let me start off a question for the panel. 
I would like to have your view on insurance that operates in 
smaller States--I am talking population-wise--as opposed to 
larger States.
    And insurance companies face certain compliance and market-
entry costs in order to do business in a State. And does this 
leave the smaller States, potentially, at a disadvantage? I 
would like to have your comment on that.
    Mr. Klein. That is a good question. I think that probably 
smaller States, perhaps, do present a little more of a 
challenge for insurers in terms of entry. I mean, basically, if 
you were to look at the number of insurers operating in a small 
market versus a large market, a small market is going to have 
fewer insurers. They are going to be less likely to make the 
expenditures necessary in order to operate within that State.
    So, I think a small State, to a certain extent, probably 
does suffer a bit in terms of entry costs or compliance 
requirements relative to the volume of business that a company 
could do in that State.
    Senator Allard. So, if they sign off on agreement that they 
are going to have a certain regulatory agreement, it might work 
out fine for the larger State, but on the smaller State, it 
would not work out so well because you have such a small 
market.
    Yes. Dr. Harrington.
    Mr. Harrington. I would say that if the regulatory 
environment is conducive to making insurance companies feel 
that they can market their products at rates that will cover 
their costs, it is really not a material issue on our modern 
markets.
    As an example, in South Carolina, where I lived for 16 
years, when they relaxed some pernicious automobile insurance 
regulation, the number of auto insurance writers went from 100 
to up to the high 100's within 12 months.
    So, at some point, smallness is a problem, but I do not 
think it is really an issue in our modern world unless the 
State does things to make it hard for companies to operate.
    Senator Allard. Yes.
    Yes. Dr. Klein.
    Mr. Klein. Yes. I would tend to agree with Scott. I think 
that if we had a system that worked the way that I would 
conceive of, and I think that the way that Scott would conceive 
of, where essentially, whether it is through an optional 
charter or it is through uniform requirements in all States, 
entry barriers in small States would not be significant. So, 
basically, an insurer creates one product and is able to sell 
it in all States, then you basically remove that cost and entry 
barrier.
    So, they can sell it in South Dakota. They can sell it in 
New York. A State's market size does not matter too much, other 
than maybe some issues relative to distribution.
    Senator Allard. If you had, with the insurance company, 
when we talk about the optional charter, you can either go 
Federal or State, are you thinking in your mind, that an 
insurer might select several States that he might get licensed 
in to sell insurance? And a Federal charter that would 
encompass that would encompass all, or are you thinking in 
terms of just one State, which might be his headquarters, and 
he insures in there, or he goes to a Federal charter?
    See what I am trying to get at? Some insurance companies 
may be able to cherry pick the market if they can pick the best 
States that have the best markets and go with those, as opposed 
to a Federal charter. And that might be 10 States as opposed to 
a Federal charter. I would like to have your comment on that 
option that might be available.
    Mr. Harrington. I would presume that an optional Federal 
chartering system would require an entity to pick. You either 
have a Federal charter and you operate nationally subject to 
that charter, or you maintain the current requirements to get 
licenses in every State where you write business.
    Now, I certainly think that companies will make that 
decision strategically and in the interest of their owners. And 
that is one of the possible advantages of moving in that 
direction. And that it will then encourage regulatory 
environments that could help to lead to entry in robust 
insurance markets.
    Senator Allard. It seems to me, maybe, more of a 
competitive market, where it would at least, as far as the 
Federal charter is concerned, might be a force that would hold 
down, you know, Federal charter rate costs. You know, what the 
insurance company would get charged for a Federal charter. Mr. 
Harrington. I think, in general, that there are advantages that 
could reduce costs associated with regulatory competition.
    Senator Allard. Yes.
    Mr. Harrington. To be sure, we do not know, yet, what might 
happen in insurance if we have optional Federal chartering. I 
am not sure that it will be that easy for insurers that choose 
the Federal charter, for example, to switch later on if they 
had to go back and get licensed in 46 States or 49 States.
    So, that could detract a little bit from the competitive 
results.
    Senator Allard. Yes.
    Dr. Klein, do you have any comment on that?
    Mr. Klein. Yes. A little bit. I think I tend to agree with 
Scott. I think that my sense would be that most of the national 
companies that operate in a large number of States would 
basically opt for the Federal charter, and that really should 
be the regulatory regime if we are going to have that kind of 
system.
    And presumably they will stay with that as long as the 
regulator and the Republicans are in the majority. But there 
could be a time--I do not necessarily want to show any 
disrespect--we could have a Democratic President and a 
Democratic regulator appointed and Federal regulation, at that 
point in time, might not look so good to certain companies. And 
so there would be a question if they would switch or could 
switch. And that could be an issue.
    But my sense is that, basically, if we went to this 
optional system, we would have a large number of national 
companies that would, basically, go for the Federal charter and 
keep their fingers crossed that the regulatory regime would 
stay reasonable.
    And you would have a withering of State insurers and you 
would have a few insurers that would just specialize in certain 
State or certain niches. And that is probably a market 
segmentation that would result.
    Senator Allard. Personally, I like to hold down the 
regulatory environment, but sometimes I do not know how much 
company I have on that effort.
    Senator Johnson.
    Senator Johnson. Well, thank you. I would only observe that 
our friends in the banking industry do not seem to be going 
back and forth between Federal and State charters depending on 
which party is in the White House. I think that the regulatory 
balance has been fairly stable there.
    Let me just ask a couple questions to each of you. One of 
the early on debates that we have had relative to a Federal 
regulator is whether that regulator is more appropriate for 
life insurance than it is for property and casualty, or whether 
we ought to stick to a more comprehensive approach, and that 
there is no necessary advantage or disadvantage either way.
    Would either of you care to comment? Is there one element 
of the insurance industry that is significantly where a Federal 
regulator more justifiable than another?
    Mr. Harrington. That is a very interesting question. I have 
not reached a final conclusion.
    But seriously, at times I think that the speed to market 
issue and the competition of life insurance companies with 
other financial institutional and the accumulation of 
management business creates an additional edge which makes it 
very, very important for them to get more uniformity and more 
rapid speed to market.
    But when I go down that route, I start thinking about prior 
approval rate regulation or property casualty insurance, 
residual market rate caps, and all of those things, as well as 
the fact that in the modern world, many of the larger entities, 
of course, have life insurance and property casualty insurance.
    So, things really are not that simple across product lines.
    Mr. Klein. And my response would be that to a certain 
extent, I think you have got a point. I think for life 
insurance and annuity products we would not expect there to be 
significant differences between States in terms of what people 
need, other than income levels might be different. So that does 
kind of lend itself, perhaps, to greater uniformity and that is 
probably one of the reasons why the NAIC has adopted uniform 
standards in that area more readily.
    But the other side of this is that I do feel, and I agree 
with Scott, that there does need to be a lot of reform on the 
property-casualty side. There is a lot of regulation there that 
simply, in my view, is not necessary, or potentially harmful. 
And the States need to make further, major moves in that area.
    And if they would be willing to do that with the type of 
institutional structure I described, that would be terrific. If 
not, then I think maybe optional chartering would have to be 
the alternative. But, one way or another, I think those changes 
need to occur, and so we have got to get there somehow.
    Senator Johnson. And Dr. Harrington, some of your 
publications in the early 1990s, you concluded that Federal 
regulation of insurance and the possible optional Federal 
charter would not have been an appropriate response and not 
justified at that time. But since then, you have concluded that 
States' regulation of rates, rate classification and policy 
forms remain dysfunctional in many States and with no obvious 
end in sight.
    Can you elaborate just a bit on what has led you to decide 
that now is the time to start considering Federal regulation or 
possibly an optional Federal charter? Were there situations and 
specific organizations and States that led you to the 
conclusion that States can no longer do an adequate job of 
insurance regulation.
    Mr. Harrington. Senator Johnson, that is an excellent 
question. I have had to really think long and hard about that 
issue.
    I think in the past 3 or 4 years I became even more 
distressed by what I observed in terms of the politics of State 
regulation. And I also became more knowledgeable and aware and 
concerned about international insurance, international 
insurance competition, and the competition between insurance 
companies and other financial institutional than I had been 
previously.
    My earlier writings, to some extent, more focused on 
insolvency problems that had arisen and arguments for Federal 
chartering that related to alleged defects in State oversight 
of insolvency. And I felt that the States had taken actions and 
done some things that had redressed those problems.
    But it is really an evolution of the modern economy, as 
well as seeing State regulation in action, in some cases, up 
close and personal, and I found it to be very distressing.
    Senator Johnson. Let me close with just one last question 
to Dr. Klein.
    In your testimony, you stated that you had a concern that 
you had with adequacy of State regulation of agents and brokers 
and noted some instances of fraud.
    Is this a symptom of the patchwork of State laws and 
regulations in this area, or do you think a Federal regulator 
would be more effective in educating and regulating agents and 
brokers in enforcing stringent standards of conduct?
    Mr. Klein. That is an interesting question. I think it does 
have something to do with a patchwork. I mean, there is a lot 
of variation and some States, I think, do a much better job of 
regulating and ensuring the competency of agents than others.
    It is possible that a Federal regulator, if it really 
focused on it properly, could do a better job of making sure 
that agents were competent and did not commit fraud or abuses.
    But, on the other hand, a good State regulator that is very 
focused, that has very good standards, is very hands-on, can be 
effective; but there is a potential for problems in States that 
have not handled that well.
    And I am sure there are a lot of instances like that.
    Senator Johnson. There is a great deal of variability. So, 
that is where the recommendation that I would make is that I 
would have uniform standards, but I would make them rigorous.
    Mr. Klein. Yes. There is a great deal of variability.
    Some of this has to do with incompetence and some of it has 
to do with outright fraud. The fraud is a problem that deserves 
a different type of enforcement approach. But the incompetence 
thing is also an issue and that really is a matter of not only 
having high competency requirements, but making sure that the 
agents continue to maintain that level of competence.
    Senator Johnson. Having some kind of Federal standard or 
Federal regulator may, in fact, be on the side of consumer 
protection.
    Mr. Klein. In that respect, it could be. Yes.
    Senator Allard. Senator from New Hampshire.
    Senator Sununu. Thank you.
    Dr. Harrington, Under Secretary Quarles spoke about what he 
perceived to be the problems with rate and price controls. I 
take it that you generally agree with his assessment.
    Is there a particular aspect of price controls, or a 
particular effect that price controls have on insurance markets 
that your research has shown to be particularly problematic?
    Mr. Harrington. The two most problematic aspects are the 
tendency for some States, occasionally, not to allow rates to 
go up on average commensurate with the growth and claim costs.
    It creates availability problems and increases residual 
markets. It also tends to lead to changes that bump around more 
than what they probably need to.
    Senator Sununu. Greater volatility.
    Mr. Harrington. Right.
    And then the other thing is very State specific, it is when 
there are decisions made, really, to hold down rates for 
certain segments of the population in ways that produce 
substantial deficits in residual markets.
    And, over time, they require greater rates for the 
voluntary market. So you end up in those mechanisms by trying 
to lower rates to some, you end up raising rates to others. I 
think that is negative sum.
    Senator Sununu. He noted that over 40 States still have 
some kind of rate and price regulation. What is the 
international experience? Do our counterparts in Europe, for 
example, still regulate prices in insurance?
    Mr. Harrington. I do not have detailed information in all 
countries, but in Europe, in general, the movement has been in 
the past 15 years, away from price regulation and toward 
reliance on competition, with some very narrow exceptions 
related to public health insurance programs.
    Senator Sununu. How would residual markets operate in an 
environment without price controls? How can Government, broadly 
speaking, a Federal regulator in this particular case, ensure 
that the main objective of residual markets continues to be met 
in a world where we do not have price limits, price caps, price 
controls?
    Mr. Harrington. Senator Sununu, that is an important 
question and a difficult one. In principle, I think that it is 
easy to say that with Federal chartering, federally chartered 
insurers should participate in State residual markets, but 
those markets must be designed so that the rates that are 
charged are self-sustaining.
    The question is, how do you actually get to that result and 
practice?
    For the types of insurance that we are generally concerned 
with, and ignoring catastrophe coverage, which can be 
troublesome, it is possible for reasonable----
    Senator Sununu. I am sorry. When you say catastrophe 
coverage, what are you talking about.
    Mr. Harrington. I think certain types of--the hurricane 
risk----
    Senator Sununu. You are talking about specialty insurance, 
not general property casualty, auto insurance.
    Mr. Harrington. For Worker's Compensation insurance, 
automobile insurance, it is quite possible to get a handle on 
what rate adequacy should be for the market of last resort.
    Many States have done this for decades and, as you know, 
their residual markets for automobile insurance have been very 
tiny, because the rates for the residual market do not crowd 
out the private sector.
    Senator Sununu. Are there any residual markets for 
hurricane insurance or earthquake insurance?
    Mr. Harrington. Yes. There are. We have the special State 
systems in some States. I do not know if they would fall under 
the rubric specifically of residual market.
    And we also have beach and windstorm plans in a number of 
the coastal States.
    Senator Sununu. But you are suggesting that there are some 
markets where insurers are forced to offer and sell hurricane 
insurance?
    Mr. Harrington. In a number of the States for many years, 
there have been regions on the coast that have been designated 
as eligible for coverage through a beach State--beach and 
windstorm plan--which is, in essence, a residual market.
    When those plants have performed well, the rates have 
helped affordability, but they have not produced large cross-
subsidies and assessments.
    Senator Sununu. But is insurers participation in those 
plans compulsory?
    Mr. Harrington. I believe it is in some States. I cannot be 
certain on all the States.
    Senator Sununu. Excellent. Thank you. You talk about it 
being ideal to narrow the scope of the guarantee funds.
    What does that mean?
    Mr. Harrington. Let me give an example. In some of the 
States, have no guarantee firm protection for large commercial 
insurance buyers that have net worth in excess of some 
threshold.
    Large entities with resources do not need to be protected 
against the consequence of their insurers' default. They can 
manage that risk and they have the wherewithal to identify safe 
insurers to keep that from happening.
    So, there is not a strong public policy reason to rope in 
large corporations as an example and give them protection. It 
is similar to banking, where you have uninsured depositors.
    Senator Sununu. Thank you.
    Thank you, Mr. Chairman.
    Senator Allard. I would like to follow up on the guarantee 
fund question that Senator Sununu was pursuing. On an optional 
Federal charter system, should the guarantee funds be 
administered at the national or the State level? And what are 
the implications of each type of administration?
    Mr. Harrington. I have not thought through what should 
happen. My thinking has been more on what I guess is likely to 
happen. I think once you have Federal-chartered insurers and 
State-chartered insurers, I think it makes perfect sense to 
have the beginning of the system be participation in the State 
guarantees by Federal-chartered insurers.
    I think there will be pressures over time that would tend 
to move toward having some nationalization of that system.
    In terms of the specific administration of a national 
system, I have not thought about it.
    Mr. Klein. Yes. I would just add to that. I agree with 
Scott about the short-term. I think over the long term there is 
a problem when the administrator of the guaranty fund, so to 
speak, or you have a situation where States regulation of 
insurers that come under its purview for financial purposes 
could potentially draw or impose costs on insurers that are, 
say, nationally regulated.
    When you get, basically, a disconnect between a regulation 
and the payers, or the guarantors, you have got a problem. Now, 
you actually have that problem right now, under the State 
system. And that could be potentially worsened with federally 
chartered insurers still contributing to State guaranty funds.
    So, I think over time that kind of conflict would need to 
be resolved. Actually, what exists, I think, in banking right 
now seems to me to make a lot of sense.
    Because, as I understand it, the FDIC guarantees both the 
Federal banks and some of the State banks. And, basically, 
their rules ultimately determine the financial standards, to a 
great degree, for those institutions.
    So, whoever the guarantor is, their standards and their 
rules ought to apply over the entities that are being covered 
so that you do not have this disconnect between the 
responsibility of guarantees and the control over financial 
risk.
    Senator Allard. And another question along the same lines, 
what are the implications of the funding guarantee funds 
through assessments after insolvency, as is currently done by 
States other than New York, as compared to a system that 
collects annual assessments regardless of insolvency, such as 
under the FDIC.
    Mr. Harrington. I like the way ex post assessment has 
worked in general in insurance markets, because, with some 
exceptions, insolvency assessments have been very minor.
    The historical risk associated with those assessments is 
the type of thing that can readily borne on an ex post basis. 
And there are mechanisms when assessments increase and they may 
hit limits for making sure that the claims get paid.
    Ex post assessments for many companies, but not all 
companies, create, I believe, additional incentives for them to 
pay attention to what regulators are doing and how effective 
solvency regulation is and how effective liquidation of 
insolvent companies is.
    It gives them, I believe, possibly, more skin in the game, 
than if they put money into a pot that accumulates over time 
which they view as gone once it leaves their coffers. And I 
think that is another useful reason to have ex post 
assessments.
    And another thing, the major advantage of charging 
insurance companies in advance would be, if you could, in 
principle, have risk-tailored premium for guaranteed 
protections, so that an insurer would have more insolvency risk 
would face a higher ex ante premium, which, in turn, would give 
them an incentive to reduce their insolvency risk.
    But I doubt that, in practice, we will ever get to the 
point where we have reasonably accurate risk-based premiums for 
guarantees for insurers. And my reason for that is 
understanding some of the politics and having observed bank 
regulation.
    Senator Allard. Do you agree, Dr. Klein?
    Mr. Klein. Pretty much. I mean, I also would like to see 
risk-based assessments, whether post or pre, and I think 
actually, you could have a risk-based post assessment, as well 
as a risk-based pre-assessment.
    But I also agree that it would be a highly politically 
charged process. Even though, theoretically, if Scott and I 
were running the system, we could probably develop good risk-
based charges, but the people that would be actually in that 
situation would be under a lot of pressure.
    So, I am not sure that you would get the result that you 
would, ideally, like to have.
    Senator Allard. Let me get back to what I was trying to get 
at in an earlier question. I am going to put this in a little 
different format.
    Let me direct this to you, Dr. Klein. Someone suggested 
that life insurance and property casualty insurance are 
fundamentally different products. Life insurance is a more 
national product, and therefore creating an optional Federal 
charter for life insurance companies is more appropriate than 
for property and casualty insurance companies.
    What is your view, and does an optional Federal charter 
make more sense for life insurers than for property casualty 
insurers?
    Mr. Klein. Well, as I indicated before, perhaps to an 
extent, there is more commonality among life insurance products 
and less of a State variation issue there.
    So, one could make that argument, but I would not take that 
too far because the argument that the conditions for property-
casualty insurance in the various States vary so much that 
uniform requirements, whether done through an interstate 
compact or done through optional chartering, or whatever, would 
not work because States are so different in terms of their 
situations is not valid in my view.
    I put in my written testimony, that I do not really buy 
that. There are some differences, but, basically, if you look 
at the property-casualty insurance products that are typically 
sold in various States, other than needing to meet different 
State laws, they are pretty similar.
    And so, I do not see variations among States being an 
argument against uniformity in product regulation in the 
property-casualty arena. And, in fact, I would advocate it for 
both, both life and property-casualty. Understanding that maybe 
in life insurance, there would be a little less of an issue or 
concern about State variation.
    Senator Allard. Dr. Harrington, do you have a comment?
    Mr. Harrington. Yes. I do. The local nature of torte 
liability law and Worker's Compensation law, I believe, at the 
margin, makes the property casualty insurance business more 
local than the life insurance business.
    But on the other hand, some of the inefficiencies 
associated with misguided regulation are particularly 
pronounced for property casualty insurance and, in particular, 
what we have been discussing in terms of rate regulation and 
residual markets.
    So, I do not have a strong opinion that one deserves more 
than the other. I think that in property casualty insurance, 
there are things that State regulators do that can have 
spillover effects on insurance buyers on other States. And at 
the margin that justifies some sort of national response.
    Senator Allard. Some have said that the reason we have put 
in place rate regulation is to prevent a race to the cheapest 
policy. And then, by doing that, they under-price their 
policies based on competition of the market. Is rate regulation 
still justified to prevent a race to the bottom as some 
suggest? And could solvency regulation take the place of rate 
regulation in making sure insurance companies maintain adequate 
reserves to pay future claims?
    Mr. Klein. OK. I will answer that first, and let Scott give 
his opinion. It is an interesting question that a lot of people 
have asked me. And, based on my research, rarely, if ever, have 
I seen a regulator disapprove a rate cut, no matter how severe.
    And a good case in point, I guess, is what Reliance was 
doing in Pennsylvania, or the other States in which it was 
operating. I mean, I am not aware of any regulators who said 
Reliance, you should not cut rates so far and keep spending so 
much money.
    I mean, for political reasons, and this basically happens 
in commercial lines, a regulator is not going to oppose a rate 
decrease. So, the only kind of situation that probably one 
could contemplate, although I do not know that this has ever 
really occurred is that if an insurer got to a point where its 
rate cuts were so severe relative to its expected losses that 
it did threaten its solvency--and admittedly, I think Reliance 
was such a case--one could make an argument that there should 
have been some earlier intervention by regulators. But for 
whatever reason, reasons I would like to know myself, that did 
not occur.
    Basically, my response is that I do not think that rate 
regulation can deal with the under-pricing phenomenon. I think 
experience has shown that.
    Potentially, a more active or proactive solvency type of 
approach could deal with the companies that cut prices so far 
that their solvency is threatened, which tends to have a 
depressing effect on the rest of the market.
    Senator Allard. Any comments, Dr. Harrington, on that 
question.
    Mr. Harrington. I agree with Dr. Klein and I think 
regulators can pay more attention to companies that they think 
might be under-pricing in the sense of taking a closer look at 
their solvency.
    But I just agree with Dr. Klein.
    Senator Allard. Let me go to something more local, as far 
as my State is concerned. Now, I understand that the NAIC is 
attempting to address one of the industry's most pressing 
concerns, and that is slow product approval through the use of 
an interstate compact.
    In Colorado, they brag about the fact that they are the 
first State to adopt the compact. Now, what are your thoughts 
on this initiative--and it seems to be moving ahead 
successively. So, is it necessary for Congress to consider an 
optional Federal charter? And, if so, why is an interstate 
compact insufficient, and what are the problems with it?
    Mr. Klein. Well, I have done a little bit of reading about 
this, but I have to admit I have not really had an opportunity 
yet to really thoroughly access how well it is working and what 
the companies think about it.
    It sounds promising, but I, at least, have a couple of 
issues. One is, will other States join this? And two, I would 
be interested in knowing what the companies who go through this 
process, what their assessment of it is, and whether they feel 
that it does satisfy their need for streamlined and uniform 
approval of products.
    So, it sounds like it is a good idea and it may be 
accomplishing quite a bit of progress, but I have not really 
been able to assess it.
    Senator Allard. As I understand it, this compact just has 
four general areas, life, annuity, disability, and long-term 
care insurance.
    Mr. Klein. Right.
    Senator Allard. Yes.
    Dr. Harrington, did you have a comment?
    Mr. Harrington. I regard it as a very positive development 
in general, but it will forever be incomplete and it is a slow 
process.
    Senator Allard. OK. I am going to draw the Committee 
hearing to a close.
    Again, I would remind this panel as well as the other panel 
that Committee members have a week with which to submit 
questions, and then we would ask that when you receive the 
questions, you get it back to the Committee within 10 days, if 
you would, please.
    I would like to thank Under Secretary Quarles, Dr. 
Harrington, and Dr. Klein for their testimony before the 
Banking Committee. Insurance regulation is a highly complex 
topic, and their testimony has aided our understanding of the 
issue. In particular, their responses during the question and 
answer period will be invaluable as we continue to explore the 
appropriate regulatory reforms.
    Just like Chairman Shelby, there are many members with 
other commitments this afternoon, and I am sure that many of 
them would like to take advantage of our witnesses' expertise 
by submitting those questions for the record. Therefore, we 
will hold the record open until the end of the week, should 
they wish to submit any questions.
    Witnesses, this is an important topic for the Committee, so 
we would appreciate your prompt response to the questions.
    Thank you all for being here today. This hearing is 
adjourned.
    [Whereupon, at 3:42 p.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]
                PREPARED STATEMENT OF RANDAL K. QUARLES
                  Under Secretary for Domestic Finance
                       Department of the Treasury
                             July 18, 2006
    Good afternoon Chairman Shelby, Ranking Member Sarbanes and Members 
of the Committee. Thank you for the opportunity to appear before you 
today to discuss the role of insurance in our economy and the need to 
modernize the regulation of insurance. This is an important topic, one 
that affects not only the efficiency and competitiveness of a 
significant U.S. industry and a central function of the U.S. financial 
system, but one that has broad consequences as well for the ability of 
our economy as a whole to innovate and to grow.
INTRODUCTION
    In the first instance, the issues surrounding insurance regulation 
are significant because the U.S. financial services industry is one of 
our country's most important areas of economic activity, and the 
insurance industry is a large part of the U.S. financial sector. 
According to the Federal Reserve, at the end of 2005, total assets held 
by U.S. insurance companies totaled $5.6 trillion, as compared with 
$11.82 trillion for the banking sector, and $10.5 trillion for the 
securities sector.
    In addition to the size and importance of the insurance industry 
considered solely in itself, however, insurance--like other financial 
services--has substantial ripple effects through the economy as a 
whole. Insurance performs an essential function in our overall economy 
by providing a mechanism for businesses and the general population to 
safeguard their assets from a wide variety of risks. The ability of 
businesses to insure against risk adds a degree of certainty to their 
planning and thus contributes to greater economic activity and enhanced 
economic growth. The general population also benefits from being able 
to purchase protection for various types of losses that would be 
difficult for individuals to absorb on their own. Insurance companies 
are in the business of managing these risks. They specialize in 
evaluating the potential for losses and perform an important function 
by spreading that risk widely across various segments of our economy 
and population.
    Insurance is also like other financial services in that its cost, 
safety and ability to innovate and compete are heavily affected by both 
the substance and the structure of its system of regulation. As a 
result, then, both of the industry's importance considered simply as a 
separate line of economic activity as well as its consequences for 
commerce and economic growth more broadly, we should seek to ensure 
that the regulatory system for the insurance industry is consistent 
with the efficient and cost-effective provision of its services and 
with continuing evolution and innovation in the design and distribution 
of its products.
    In that regard, there appears to be virtually no disagreement that 
the current State-based insurance regulatory system could benefit from 
further modernization. There have been a variety of approaches that 
have been considered: State-driven efforts at reform, total Federal 
preemption of the State-based system, the setting of Federal standards 
for States to administer, and the creation of a dual chartering 
structure that would allow insurers to opt for either State or Federal 
regulation.
    Unlike the banking and securities sectors, insurance is solely 
regulated at the State level, and while this multiplicity of regulators 
can provide certain benefits in the form of local expertise and 
control, it does raise a number of issues that deserve further 
consideration. In our view, those issues fall into three main 
categories:

    Potential inefficiency, resulting both from the substance 
        of regulation (especially price and form control) but also from 
        its structure (the inevitable duplication and cost associated 
        with multiple non-uniform regulatory regimes);

    International impediments, both questions of comity 
        (facilitating international firms' operations in the United 
        States, which benefits U.S. consumers) and competitiveness 
        (facilitating U.S. firms' operations abroad, which provides 
        growth opportunities for U.S. industry and helps diversify 
        their risk exposures);

    Systemic ``blind spots'', the inability of the official 
        sector to understand and respond to the insurance sector's 
        evolving contribution to risks affecting the financial system 
        as a whole.

At the most fundamental level, the question posed in each of these 
areas is whether our current system of insurance regulation is up to 
the task of meeting the challenges of insurance regulation in today's 
evolving and increasingly global insurance market. More broadly, we 
should evaluate whether the benefits of regulatory competition (which 
are fostered by our existing structure or other multiple-regulator 
structures) are outweighed by the costs of regulatory fragmentation 
(which are significant in a 50-State system).
BACKGROUND
    The current structure of insurance regulation in the United States 
is the result of a long history. In 1868, the U.S. Supreme Court 
concluded that the issuance of an insurance policy was not interstate 
commerce, and therefore outside the constitutionally permitted scope of 
the Federal Government's legislative and regulatory authority (Paul v. 
Virginia). In 1944, some 76 years later, the Court reversed itself 
holding that insurance was indeed subject to Federal regulation and 
Federal antitrust law (United States v. South-Eastern Underwriters 
Association). In 1945, before any assumption of Federal regulatory 
authority over insurance, Congress passed the McCarran-Ferguson Act, 
which ``returned'' the regulatory jurisdiction over the business of 
insurance back to the States, and generally exempted the business of 
insurance from most Federal laws provided such activities were 
regulated by State law.
    Under the current State-based regulatory system, each State has a 
chief insurance regulator, generally referred to as ``commissioner,'' 
who is charged with administering State insurance laws, promulgating 
regulations, and other duties pertaining to the supervision of the 
business of insurance. In most States the insurance commissioner is 
appointed by the Governor. In 11 States, including California, the 
commissioner is elected. Each State commissioner is a member of the 
National Association of Insurance Commissioners (NAIC) that was founded 
in 1871. The NAIC is the primary vehicle through which State insurance 
regulators exchange information and coordinate activities to enhance 
the effectiveness of insurance regulation.
    State insurance regulation can be divided into two broad 
categories:

    Solvency or financial regulation aimed at preventing 
        insurer insolvencies and mitigating consumer losses should 
        insolvencies occur; and

    Consumer protection and market regulation focused on 
        potential anti-consumer practices.

    Each State enacts State-specific insurance laws. The NAIC has 
developed model laws and regulations covering various aspects of the 
insurance business in an effort to achieve greater uniformity. In the 
solvency and financial regulation area these range from accounting and 
investments to solvency/market examinations, holding companies, insider 
trading and proxies, and reinsurance. In the consumer protection area 
these model rules cover matters ranging from privacy protection, 
deceptive advertising, unfair policy terms, and discriminatory or 
unfair treatment of policyholders. Many model laws must be approved by 
State legislatures before they can be implemented, while some States 
may have the authority to adopt model regulations in certain areas 
without legislative action. The adoption of model laws and regulations 
has been spotty at best. It is a cumbersome process that, in many 
cases, can take a number of years. It also allows for variation in 
implementation across States.
    The State-based insurance regulatory system was subject to 
significant criticism in the 1980s after several major insurance 
companies became financially impaired. At that time, there were calls 
for regulatory reform, including a proposal for a preemptive Federal 
regulator. State insurance regulators, sensing that the State-based 
system was in jeopardy, made some impressive strides in undertaking 
initiatives to reform State solvency regulation. They established an 
NAIC Accreditation Program requiring the adoption of designated model 
laws and regulations, and a review of the insurance regulatory agency 
of each State by an independent review team to assess compliance with 
the required standards. As a result, today there is a relatively 
uniform solvency regime that has been implemented across the States. 
However, in other areas of regulation, the States appear to be much 
more reluctant to adopt uniform standards.
    Another important aspect of the State-based insurance regulatory 
system is its system of guaranty funds. Unlike the system that is in 
place for federally insured depository institutions, there is not a 
Federal guarantee ensuring that policyholder claims are paid. Each 
State operates its own guaranty fund, and typically separate funds are 
maintained for property/casualty insurance (mostly personal lines) and 
life/health insurance. If an insurer becomes insolvent, the State 
insurance regulator typically is appointed as the liquidator. As 
liquidator, the regulator appoints a receiver to manage the 
liquidation. The guaranty fund then works with the receiver and assumes 
responsibility for the payment of a specified portion of the claims 
that would otherwise have been paid by the insurer. The State-based 
guarantee system is funded primarily on a post-assessment basis, with 
all insurers that write particular types of business being subject to 
an assessment to fund losses.
KEY ISSUES IN CONSIDERING INSURANCE REGULATORY            MODERNIZATION
    An important part of this debate is what should be the role, if 
any, of the Federal Government in insurance regulation. While the 
State-based system has a number of potential merits--such as local 
knowledge of insurance market conditions and preserving local 
decisionmaking over key aspects of activity within a particular State--
it does raise a number of issues that need to be considered as 
financial markets evolve in this country and abroad. The key issues I 
will focus on today are: potential inefficiencies associated with the 
State-based system--most prominently undue regulatory burden and price 
controls; international implications for free markets and 
competitiveness; and fully understanding the impact of the insurance 
sector on financial sector soundness.
Potential Inefficiencies of the State-based System
    As I indicated, there is virtually no dispute over the fact that 
there is a general need for modernization of the current State-based 
system. One aspect of modernization has been a focus on the lack of 
uniformity in State regulation. Even though the NAIC has achieved some 
success over the past 135 years in fostering more uniformity among the 
States, many of its model laws and regulations have not been enacted by 
the States. States interpret these model laws differently, and craft 
individualized exceptions to them. This should not be a surprise given 
that the general nature of State legislatures and regulators to 
preserve authority in areas where it is perceived to be warranted.
    Nonetheless, differing State insurance regulatory treatment can 
lead to inefficiencies and undue regulatory burden. This can directly 
limit the ability of insurers to compete across State boundaries. 
Reduced competition can diminish the quality of services, consumer 
choice, and ultimately lead to higher prices.
    At the most basic level, States have individual requirements that 
insurers and producers (i.e., agents and brokers) must meet to operate 
in each State. For example, all insurers must receive a license from 
each State in which they plan to do business. While the NAIC has tried 
to simplify this procedure, the filing requirements for licenses can 
vary significantly from State to State and companies must still 
ascertain and comply with those requirements.
    All States also require a license from those who wish to sell 
insurance, and the licensing process also varies from State to State. 
The multi-State licensing of insurance producers has been somewhat 
streamlined in recent years thanks to the provisions of the Gramm-
Leach-Bliley Act, which provided for a Federal preemptive producer 
licensing system (the National Association of Registered Agents and 
Brokers) that served as a threat to the States to develop a more 
unified system. The States responded and established a system that 
established the required reciprocity arrangements. Reciprocity 
arrangements have somewhat streamlined the process; however, agents 
must still obtain a license in each State in which they do business.
    Another area of potential inefficiency is form approval regulation. 
Form approval is the system or process by which State insurance 
regulators review and approve (or disapprove) policy forms insurers 
wish to use in a State. There are at least seven categories of State 
policy form approval systems, including the use of State required 
forms, strict prior approval of forms, ``file and use,'' ``use and 
file''--to no form filing required. State form approvals can be based 
on any number of factors. For example, some States require certain 
disclosures and descriptions of coverage, some even specify the proper 
typeface sizes and the color of ink, as well as specifying that the 
disclosure has to be on the first page of the policy--a requirement 
that can make an insurer have to have State-specific cover pages for 
their policies. Some States also require special disclosures for 
particular products such as small face amount life insurance policies, 
or special ``buyer's guides'' or policy endorsements for certain 
products. Requirements for descriptions of coverage can also vary from 
State to State, with some States requiring the language text itself to 
be based on specific readability standards, such as a minimum score of 
40 on the Flesch reading ease test or compliance with some other test 
approved by the commissioner.
    The NAIC made efforts to achieve a higher degree of uniformity in 
product approvals by launching such programs as CARFRA (Coordinated 
Advertising, Rate and Form Review Authority) and SERFF (System for 
Electronic Rate and Form Filing). In addition, just last month some 27 
States entered into an Interstate Insurance Product Regulation Compact 
that would provide for uniform national product standards for the 
products sold by life insurers (life insurance, annuities, disability 
income insurance, and long-term care insurance). While these efforts 
may lead to some degree of greater uniformity, it is still up to each 
State to interpret and enforce such standards.
    States justify form approval as a necessary tool for consumer 
protection. However, there should be a careful analysis of the cost and 
benefits of these requirements at the individual State level. In 
addition, having multiple technical State requirements makes it very 
difficult, and very costly, for an insurer to roll-out a new product on 
a nation-wide basis.
    Perhaps the greatest potential for inefficiency in the current 
State-based system is with price controls. Insurance is perhaps the 
last major market in the United States with direct price controls. The 
term ``price controls'' is frequently used to describe State regulation 
of rates used by property/casualty insurers licensed or admitted in a 
State (referred to as the ``licensed/admitted market''). This market 
includes such personal lines of insurance as automobile and homeowners, 
as well as a substantial portion of the commercial lines of insurance 
such as fire, burglary, theft, workers compensation, and commercial 
automobile. The basic legal standard for rates in all States is that 
they not be ``inadequate, excessive, or unfairly discriminatory.'' In 
the early years of State insurance regulation, the emphasis was more on 
whether rates were adequate, and thus would prevent solvency problems. 
However, more recently it seems as though most of the controversy over 
price controls has concerned efforts of State regulators to hold down 
prices for their constituents by denying rate increases on grounds that 
they are excessive.
    States address rate regulation in a number of different ways. For 
example, as to rates on most lines of commercial property/casualty 
insurance; 5 States have no filing requirements (No File); 2 require 
informational rate filings only (Information Only); 9 allow rates to be 
used without pre-filing, but they must be subsequently filed (Use and 
File); 13 require filing before they are used (File and Use); and 19 
require rates to be filed and approved before they are used (Prior 
Approval). Of the 43 States with some degree of rate control, many also 
provide for the exemption of rate approval requirements on certain 
large commercial property/casualty policies based on the amount of the 
premium charge or size of the policyholder.
    One of the fundamental principles of economics is that price 
controls result in inefficient outcomes. If the mandated price is set 
above the market clearing price, the result will be surpluses; if the 
mandated price is set below the market clearing price, the result will 
be shortages. The latter outcome is what we generally observe in 
insurance markets with strict price controls. When insurers are unable 
to charge what they feel is an adequate rate for their product, they 
generally tighten their underwriting standards in order to limit their 
writings to ``preferred'' risks that are less likely to suffer an 
insured loss. Not being able to charge an adequate rate also limits 
insurers' abilities to price on the basis of measurable differences. To 
the extent that prices do not accurately reflect differences in risk, 
low-risk consumers are effectively forced to subsidize high-risk 
consumers. This obviously leads to shortages in the voluntary market, 
or a ``tightening market,'' and increases demand on what is referred to 
as the residual markets. Residual markets, known also as ``shared'' or 
``involuntary'' markets or ``markets of last resort,'' are State-
sponsored mechanisms that provide consumers with another way to obtain 
automobile, property, or workers compensation insurance coverage.
    For example, where a driver with a history of multiple accidents 
applies for insurance, an insurer might be willing to write the 
coverage if it could charge a rate commensurate with the risk. However, 
if that rate was more than the State regulator allowed it to charge, 
then the insurer would likely refuse to write the policy. If no other 
insurer in the voluntary market were willing to issue coverage at an 
approved rate, then the driver could apply to the State's residual 
market (sometimes referred to as the ``assigned risk pool.'')
    All licensed insurers in a State are generally required to 
participate in that State's residual markets, typically by assuming a 
fair share of the residual market's operating results. Residual market 
programs are rarely self-sufficient, and where the premiums received 
are insufficient to support the program's operation, insurers are 
generally assessed to cover the resulting deficits.
    The residual market mechanism is the way that States address the 
shortages that are caused by price controls. While it is theoretically 
possible for the price control/residual market mechanism structure to 
duplicate the result that would occur in the absence of price controls, 
that outcome seems highly unlikely. At the most basic level, given that 
the residual market mechanism structure requires all insurers to share 
in the fortunes of the residual market mechanism, as the size of the 
residual market grows, it would be likely that fewer and fewer insurers 
would be willing to do business in that line of insurance. As insurers 
pull back from that line of insurance, further pressure is placed upon 
the residual market mechanism. So in a broad sense, one potential 
outcome of the price control/residual market mechanism structure is 
that it artificially restricts the number of insurance suppliers in a 
particular market. States typically respond to this outcome by 
adjusting prices to preserve the viability of that particular market.
    Most evidence indicates that there is a strong correlation between 
the size of residual markets and price controls: the larger the 
residual market you find in a State, you will also generally find a 
tighter market and a higher degree of rate inadequacy--often the result 
of price controls. In other words, price controls generally result in 
elevated residual market populations when the permitted rates are lower 
than indicated by market forces.
    Automobile insurance is often cited as an example of problems with 
State price controls. In 2004, the average nationwide percentage of 
private passenger cars insured through residual market mechanisms was 
1.5 percent. However, in States with more restrictive price controls, 
such as North Carolina and Massachusetts, the percentage of private 
passenger cars insured through the residual market was, respectively, 
24.2 percent and 6.5 percent. In general, States with a less 
restrictive regulatory environment (e.g., Illinois and South Carolina) 
are generally characterized by lower and less volatile loss ratios, 
smaller residual markets, and insurance expenditures below the national 
average.
    Another example is workers' compensation insurance, which is often 
pointed to as the line of insurance with the greatest degree of rate 
regulation. In the last few years, the percentage of workers' 
compensation premiums in residual markets has been on the increase. 
Among those States that report through the National Council on 
Compensation Insurance (25) the residual markets' share has increased 
from 3.2 percent in 1999 to 11.5 percent in 2005, and was even as high 
as 12.7 percent in 2004. There is also wide variation among individual 
States, with 2005 market shares ranging from 1.1 percent in Idaho to 
highs of 22.7 percent in New Jersey and 20.5 percent in Massachusetts.
International Issues
    U.S. firms and firms from abroad in insurance, banking, and 
securities compete across the globe and around the clock. Clearly 
foreign sources of insurance capital are important for a robust U.S. 
insurance market.
    As noted above, the lack of uniformity in our State-based insurance 
system has the potential to lead to inefficiency and undue regulatory 
burden. While all insurance companies that are licensed to operate in 
the United States are subject to same regulatory standards, foreign 
firms likely find adapting to such standards more difficult. From the 
international perspective, issues that have been raised in bilateral 
financial regulatory discussions with foreign officials are that our 
insurance market has at least 50 different regulators, and they or 
their insurance companies have no single regulator to coordinate with 
on insurance matters. Navigating the State-based insurance regulatory 
structure is likely a challenge for a new foreign company seeking to do 
business in the United States and has likely impeded the flow of 
capital into the United States to some degree. Issues that have been 
brought to our attention include: rate and form approvals; capital 
adequacy standards; and guarantee fund membership.
    The U.S. insurance market, in particular the global nature of 
insurance, is vastly different than it was six decades ago when 
McCarran-Ferguson was enacted. To give an example of the sort of 
efforts underway internationally, the European Union (EU) is continuing 
its work on its Solvency II project focused on insolvency risk for 
insurers in preparation for its scheduled introduction on an EU-wide 
basis in 2010. Solvency II is an important undertaking for it 
encompasses quantitative capital requirements, a supervisory review 
process expected to harmonize the procedure in Europe, and it will 
conform to disclosure requirements with those of the international 
accounting standard-setters. This is all part of the effort to forge 
one insurance market for the twenty-five member States in the EU. 
Reflecting the growing international nature of the markets, the NAIC is 
working closely with international regulators on a number of projects, 
such as Solvency II in the EU, on international accounting standards, 
and others. The NAIC itself is not a regulator but facilitates 
communications among the States on international regulatory issues. To 
that end, it engages in regulatory cooperation with international 
insurance regulators and through Memoranda of Understanding (MOUs), and 
supports individual members by providing technical assistance to 
regulatory agencies. The NAIC also coordinates closely with Office of 
the U.S. Trade Representative in international financial services 
negotiations, and it participates in Treasury's financial markets 
regulatory dialogues with various countries, including China, Japan, 
and the EU.
    To sum up, there is significant work underway in international 
insurance regulation to reflect the changes taking place in the United 
States and global insurance markets. In evaluating proposals to 
modernize our system of insurance regulation, we, too, need to consider 
what will best serve us in maintaining an insurance marketplace that 
attracts capital and does not set up artificial and costly barriers. A 
number of countries are pushing forward with regulatory systems seeking 
more uniform, efficient and stronger insurance sectors, in order to 
underpin more and better products for their consumers with less risk to 
the financial system.
Lack of Federal Understanding of Risk in the Insurance Market
    As previously noted, the insurance sector is a critical part of the 
broader U.S. economy and in terms of size alone a key participant in 
the U.S. financial sector. In comparison to other financial 
institutions, it could be argued that financial problems at an insurer 
or reinsurer pose less potential to generate broad economic problems or 
pose systemic risk in the financial system. The immediate financial 
problems from the failure of a large insurer or reinsurer could be 
limited given the nature of insurance contracts (e.g., delayed 
payments, dispersed risks, and timing of in force coverage) and the 
general funding strategies of many insurers (e.g., a focus on meeting 
potential near term liquidity needs to pay claims). Nonetheless, there 
remains some potential for disruptions in the insurance market to 
impact economic activity and financial markets. And importantly, these 
potential risks may not be well understood at either the State or 
Federal level.
    At the most basic level, the failure of a large insurer or 
reinsurer could place stress on State guarantee funds and to 
policyholders that do not have guarantee fund protection (mostly large 
commercial organizations). This could in turn have a negative impact on 
the broader economy, which could also impact other financial 
institutions. While market participants should perform their own due 
diligence when they enter into insurance contracts, given the magnitude 
of potential consequences of a large insurer insolvency the Federal 
Government should have a better understanding of the nature and 
potential for such an event.
    Given that the insurance sector is also a direct participant in a 
number of financial markets, either through direct credit exposures or 
through derivative counterparty relationships, financial problems at 
insurers could be transmitted throughout the broader economy. For 
example, there has been a considerable amount of attention paid to the 
expanding credit derivatives market. While there are a number of issues 
that might warrant attention, as with many other derivative contracts, 
a credit derivative is very similar to an insurance policy that pays 
off when certain credit events occur. Given the close correlation to 
insurance, insurance companies appear to be taking a more active role 
in this market. From an overall perspective of market stability, do we 
fully understand what risks insurance companies are undertaking, or how 
their activity could impact the credit derivatives and other financial 
markets?
    In addition to broad areas of financial sector stability, there has 
been a convergence across some product lines that are offered by 
banking, securities, and insurance firms. This is particularly true in 
regard to wealth management products. Many wealth management products 
serve a similar purpose (e.g., variable rate annuities and mutual 
funds), but are offered by firms with different charters and underlying 
regulatory structures. Any underlying economic reason for treating like 
products differently for regulatory purposes has blurred over time. 
Much like the State-based insurance system, differing regulatory 
treatment for like products adds complexity and creates potential 
problems for the free flow of capital. Given the general efficiency of 
capital markets, differences in regulation (whether through capital 
standards, product approval standards, or otherwise) and differences in 
tax treatment can direct capital flows away from their most efficient 
uses. These are all areas where the Federal Government should have a 
better understanding of potential implications.
    What should be apparent is that the insurance industry is extremely 
complex. While the State-based system has made improvements in solvency 
and holding company regulation, under a structure with over 50 
different regulators it may even be somewhat difficult for individual 
State regulators to get a firm handle on the risks that large complex 
insurance companies pose to our Nation's insurance system. Add into 
that mix that the Federal Government has little to no role in the 
State-based insurance regulatory system, and we are left with what 
could be a large blind spot in evaluating risks that are posed to the 
general economy and financial markets.
CONCLUSION
    To sum up, it is clear to us--as we think it is to most observers--
that our current system of insurance regulation requires modernization 
to meet the challenges facing the insurance industry, and financial 
services, generally, in the 21st century. Our existing system of 
regulation has the potential to lead to inefficient economic outcomes 
(raising the cost and reducing the supply of many insurance products), 
deters international participation in our domestic markets (again 
raising costs and limiting consumer choice), creates obstacles to our 
own insurance firms' international expansion, and limits the ability of 
any one regulator to have an overview of risk in the insurance sector 
and its contribution to risk in the financial system more broadly. 
These are issues of importance not just to the insurance industry, or 
even the larger financial services industry, but to the economy as a 
whole, because of the essential role that the mitigation of risk 
through insurance has in promoting commercial activity and enhancing 
economic growth.
    Treasury has been closely monitoring the developments of the 
various approaches to modernizing insurance regulation--ranging from 
the self-initiated approaches of the State regulators, and establishing 
Federal standards for the harmonization of State insurance rules, to 
the concept of an optional Federal charter now being considered by this 
Committee. While we are still evaluating what approach we believe to be 
the most appropriate, what is clear is that each of them should be 
evaluated in light of the fundamental issues we have discussed today. 
Again, thank you for addressing the issue of insurance regulatory 
modernization and for giving me the opportunity to express the 
Treasury's views. We look forward to continuing this dialogue.
                                 ______
                                 
                STATEMENT OF SCOTT E. HARRINGTON, Ph.D.
              Alan B. Miller Professor, The Wharton School
                       University of Pennsylvania
                             July 18, 2006
     Good afternoon Mr. Chairman and members of the Committee. My name 
is Scott Harrington, and I am pleased to provide my perspectives on 
insurance regulation. During my 28-year career in academia, much of my 
research has focused on the economics of insurance markets and 
insurance regulation. Many of my publications have dealt specifically 
with insurance rate regulation, with solvency regulation, with the 
performance of State regulation, and with possible Federal intervention 
in insurance regulation.
    In the early 1990s I published two papers dealing, respectively, 
with insolvency problems in the property/casualty and life/health 
insurance sectors. I concluded that Federal regulation of insurance 
would not be an appropriate response to those problems. In 2002 I wrote 
a monograph for the Alliance of American Insurers on possible optional 
Federal chartering and regulation of property/casualty insurance 
companies. I concluded that optional Federal chartering was not 
justified at that time.
    Earlier this year, I prepared an issues paper on possible Federal 
intervention in insurance regulation for the Networks Financial 
Institute, on which much of this statement is based. Despite a number 
of positive and incremental reforms in State insurance regulation 
during the past decade, I highlighted that several key aspects of State 
insurance regulation, including regulation of rates, rate 
classification, and policy forms, remain substantially dysfunctional in 
many States--with no end in sight and with significant burdens on 
interstate commerce. I concluded that a transformation of insurance 
regulation was necessary to promote healthy price and product 
competition and to eliminate regulatory micromanagement of price and 
product decisions, and that such transformation could not be achieved 
without Federal intervention.
    In the remainder of my statement I will first elaborate on the key 
shortcomings in State insurance regulation. I will then turn to 
potential benefits, risks, and design issues for optional Federal 
chartering. I will also briefly discuss alternative modes of Federal 
intervention that might redress State regulation's problems without 
creating a Federal regulator.
State Regulation's Performance
    The economic rationale for government regulation of business 
activity is to protect the public interest by efficiently mitigating 
market failures. Regulation should only be undertaken if there is a 
demonstrable market failure compared to the standard of a reasonably 
competitive market and there is substantial evidence that the benefits 
of regulation will exceed its direct and indirect costs. Economically 
efficient regulation also requires matching the appropriate regulatory 
tool to the specific market failure.
    Given the competitive structure of most modern insurance markets, 
the main economic rationale for regulation of the insurance business is 
to cost-effectively reduce the extent to which insurance companies or 
intermediaries misrepresent what is being promised at the time of sale, 
or fail to keep their promises through insolvency or deficient claims 
settlement. Achieving that objective requires regulatory oversight of 
insurance company solvency. It also favors some regulatory oversight of 
sales and claim practices to supplement competitive market discipline 
and contractual and tort liability remedies for fraud, 
misrepresentation, and breach of contract.
    In contrast to the early 1970s and early 1990s, the current debate 
over insurance regulation has relatively little to do with solvency 
regulation. The main characteristics of State solvency regulation--
regulatory monitoring, controls on insurer risk taking, risk-based 
capital requirements, and limited guaranty fund protection--are 
sensible given the economic rationales for regulating solvency and for 
partially protecting consumers against the consequences of insurer 
default. Having regulators in an insurer's State of domicile play a 
lead role in solvency regulation reduces duplication in effort and 
cost. A significant degree of coordination and uniformity among the 
States has been achieved through the National Association of Insurance 
Commissioners (NAIC), including through its promulgation of financial 
reporting requirements and its solvency regulation certification 
program.
    The State guaranty system of limited, ex post assessments to pay a 
portion of insolvent insurers' obligations is appropriate and has 
worked reasonably well, despite a large increase in required 
assessments this decade. Systemic risk (the possibility that failure of 
one insurer or rumors of trouble could produce a run that would 
adversely affect otherwise solvent insurers) is significantly smaller 
for insurers, especially property/casualty insurers, than for 
commercial banks, thus reducing the need for comprehensive guarantees. 
Limited guaranty protection helps reduce the moral hazard problem, 
whereby guarantees reduce policyholders' incentives to buy coverage 
from safe insurers. Ex post assessments avoid the accumulation of funds 
that could be appropriated by legislatures for non-insurance purposes. 
Compared with pre-funding, the responsibility for assessments also 
could increase incentives for financially strong insurers to press for 
effective solvency surveillance and efficient liquidation of insolvent 
insurers.
    There are two broad problems, however, with other aspects of State 
insurance regulation. First, too much time and money are wasted on 
administering and complying with diverse regulations across the States, 
which often are either unnecessary or deal with activities that are 
amenable to less oversight, less bureaucracy, and much more uniformity 
across jurisdictions. Second, insurance regulation is often used for 
political ends to redistribute income among insurance buyers. These 
redistributive activities generally are economically inefficient, and 
they typically are opaque to the public.
    There are four specific issues with State regulation's performance:

  1.  Costs and delays associated with regulatory approval of policy 
        forms in 51 different jurisdictions.

  2.  Costs, delays, and possible short-run suppression of rates below 
        costs associated with regulatory approval of insurers' rate 
        changes.

  3.  Restrictions on insurers' underwriting (risk selection) decisions 
        and risk classification systems.

  4.  State mandates that insurance policies provide coverage for 
        certain types of benefits or losses.

The saliency of these issues varies across States and types of 
insurance.
Prior Approval of Forms
    The NAIC and many State regulators and legislatures have taken some 
steps to streamline and homogenize the form approval process for life 
insurance and annuities, including creation of an interstate compact 
for approval of some forms. However, the continued patchwork process by 
which life insurers have to obtain approval for their products under 
State regulation and the associated costs, delays, and refusals place 
life insurers at a competitive disadvantage with federally regulated 
competitors in the asset accumulation and management business. The form 
approval issue is also important for property/casualty insurers and to 
a lesser extent (apart from the mandated benefits issue) for health 
insurers. Except for States that have substantially eliminated prior 
approval of policy forms for ``large'' commercial risks, property/
casualty insurance policy forms are subject to regulatory approval in 
all States, with associated direct costs, compliance costs, and delays. 
Prior regulatory approval of policy forms is unnecessary and counter-
productive for commercial lines of property/casualty insurance, except 
perhaps for very small businesses.
Prior Approval of Rate Changes
    Market structure and entry conditions are highly conducive to 
competition in most types of insurance. Modern insurance markets that 
are relatively free from regulatory constraints on prices and risk 
classification generally exhibit strong evidence of competitive conduct 
and performance. Insurers vary substantially in terms of price, 
underwriting, and service.
    Competition creates strong incentives for insurers to forecast 
costs accurately and to price and underwrite so as to avoid adverse 
selection, thus producing highly and increasingly refined systems of 
rate classification. Prices vary across insurers in relation to rate 
classification systems and underwriting standards. Substantial 
evidence, including small ``residual markets'' in States with little or 
no regulatory intervention in pricing, indicates that competition in 
pricing and risk selection promotes the availability of coverage if 
rates are sufficient to cover expected costs and provide insurers with 
a reasonable expected profit.
    Prior approval rate regulation cannot be justified as a response to 
monopoly or oligopoly pricing in insurance markets, nor can it be 
justified as necessary to prevent collusion, or to protect consumers 
from inadvertently purchasing coverage from high price insurers. Prior 
approval regulation produces significant administration and compliance 
costs, which are ultimately borne by consumers. The rate approval 
process has sometimes been contentious and biased toward rate 
suppression that distorts the supply of coverage.
    Prior approval regulation generally cannot be expected to affect 
insurer profits in the long run. Insurers must expect a reasonable 
profit over time in order to continue to supply coverage. Even when 
prior approval rate regulation allows adequate rates on average, the 
rate filing and approval process impedes timely adjustments of rates to 
new information about expected costs. This regulatory lag tends to 
produce fewer but larger rate changes and greater swings in 
availability of coverage and insurer profitability. Uncertainty about 
approval of proposed rate changes increases insurers' risk, with 
possible adverse effects on insurance buyers in other States. 
Regulatory suppression of rates in some States during some time periods 
reduces voluntary market sales by current insurers, increases residual 
market size, reduces entry by new insurers, and reduces incentives for 
insurers to provide valuable services and to invest in product 
distribution and service.
    Progress has been made among the States in reducing the scope of 
prior approval regulation. It is virtually certain, however, that a 
significant number of States, including some of the largest, will 
retain such policies unless motivated to change through Federal action. 
The reasons are basically political. State legislators and regulators 
benefit when they claim to save consumers money. Some consumers are 
deeply suspicious of insurers and resent having to pay significant 
amounts of their income for insurance. Some consumer organizations, 
with ready access to major media, continue to press for rate regulation 
and to condemn ``deregulation,'' claiming that ``true'' competition 
does not exist. Perhaps more important, the regulatory staffs in some 
States appear wedded to the mistaken notion that price controls protect 
consumers and serve a useful social purpose.
Classification and Issue Restrictions
    Some States directly and significantly restrict insurance 
underwriting and rate classification for health insurance (e.g., 
``community rating'') and/or some types of property/casualty insurance 
(e.g., restrictions on rate variation across geographic regions within 
a State). These restrictions generally lower premium rates for high-
risk buyers and raise rates for low-risk buyers. In order to ensure 
that high-risk buyers can obtain coverage at rates that insurers 
recognize as lower than expected costs, insurers are required to offer 
coverage to virtually all applicants under ``guaranteed issue'' or 
``take-all-comers'' requirements.
    Guaranteed issue and rating restrictions may allow some high-risk 
buyers to purchase coverage who otherwise might find it difficult to 
locate a willing health or property/casualty insurer. But their 
predominant motivation and function is to lower premium rates for 
buyers with relatively high expected claim costs by charging above-
market premium rates for buyers with relatively low expected claim 
costs. In the case of health insurance, in principle this might help 
higher-risk persons afford coverage, receive the types and quality of 
medical care that flow to insured persons, and cut down on both costly 
emergency care and bad debts for hospitals and providers. In the case 
of auto liability insurance, it may encourage more drivers to comply 
with compulsory insurance requirements, thus reducing the number of 
uninsured motorists and costs borne by other parties.
    However, significant restrictions on rating and risk selection and 
guaranteed issue requirements have serious drawbacks, including:

  1.  Average premium rates tend to go up as more high risks insure and 
        some low risks reduce or drop coverage.

  2.  Competitive rating and risk classification provide some incentive 
        for higher-risk buyers to take actions to control losses and 
        thus qualify for lower premiums and/or have lower uninsured 
        losses (e.g., by forgoing construction or employing damage 
        resistant construction in disaster prone areas, by purchasing 
        crash-resistant vehicles, by installing security systems in 
        homes or businesses, and so on). Restrictions on classification 
        dull those incentives, increasing losses and premiums over time 
        for the insured population.

  3.  When insurers are forced to accept applicants at regulated rates 
        that are below expected costs for some buyers and above 
        expected costs for others, it is very likely that the relative 
        proportions of under- and over-priced buyers will vary across 
        insurers. Some State reinsurance or risk-adjustment mechanism 
        generally is needed to ensure a stable market. Such mechanisms 
        involve significant administrative and compliance costs, and 
        they can distort insurers' incentives for cost-effective 
        monitoring and settlement of claims.

    These problems help explain why many States have eschewed such 
policies. In the case of automobile insurance, the bulk of the States 
use residual market mechanisms (mostly assigned risk plans) to narrowly 
target intervention to ensure availability of coverage to the 
relatively few buyers who might find it hard to locate a willing 
insurer. On the other hand, some States have used voluntary market rate 
caps and residual markets as an alternative method of holding down 
rates for high-risk buyers in automobile or workers' compensation 
insurance. The result has been large residual market deficits and the 
need for voluntary market insureds to pay higher rates to subsidize 
those deficits. In the case of health insurance, over 30 States have 
established high-risk pools to guaranty coverage to persons with 
chronic health conditions at subsidized rates, including all 
jurisdictions without any other guaranteed issue requirements. The 
pools generally are designed to provide subsidized coverage to a 
relatively narrow, high-cost segment of the public.
Mandated Benefits
    A complex web of ``mandated benefit'' requirements, which require 
that if a certain type of insurance is purchased, then it must cover 
specified losses, characterizes the State-based system of insurance 
legislation and regulation. Benefit mandates are most prevalent and 
debated for health insurance. Many observers argue that health 
insurance mandates produce significant increases in the cost of health 
coverage in some States, and significant reductions in the number of 
people covered by private health insurance.
    Mandates for other types of insurance in many States include 
requirements that homeowners and/or auto insurance policies cover tort 
liability claims brought by one family member for injuries caused by 
another; requirements that auto insurance buyers buy coverage for 
losses caused by uninsured motorists, including pain and suffering; and 
mandates (mooted by the Terrorism Risk and Insurance Act and its 
extension) that property insurance policies cover fire losses caused by 
terrorism and in some States prohibit any terrorism exclusions. Many 
States also significantly limit allowable deductibles and co-payments, 
which can significantly drive up the cost of coverage.
    Many mandates are argued to serve some consumer protection 
function. In reality, and when they are not simply redundant (i.e., 
mandating what a large majority of buyers would willingly insure), 
mandates often simply force people or businesses to purchase and pay 
for insurance coverage of losses they would not willingly insure. In 
contrast to the cases of compulsory liability insurance laws and 
compulsory workers' compensation insurance laws, there would be little 
or no spillover on other parties without such mandates.
Optional Federal Chartering
    The American Bankers Insurance Association, the American Council of 
Life Insurers, and the American Insurance Association agree on a number 
of principles for optional Federal chartering to encompass life and 
property/casualty insurers:

  1.  Creation of a Federal regulator to license insurers choosing a 
        Federal charter and regulate solvency, market conduct, and 
        accounting of federally chartered entities.

  2.  Exemption of federally chartered insurers from prior approval 
        rate regulation and burdensome form approval requirements.

  3.  Preemption of State rules to help ensure a single set of Federal 
        rules for federally chartered insurers.

  4.  Participation of federally chartered insurers in the State 
        guaranty fund system, subject to Federal minimum standards.

  5.  Repeal of the McCarran-Ferguson limited antitrust exemption for 
        federally chartered insurers.

  6.  Payment of State premium taxes by federally chartered insurers.

The National Insurance Act of 2006 (S. 2509), introduced by Senators 
Sununu and Johnson, incorporates most, if not all, of these principles.
    Optional Federal chartering along these basic lines would 
streamline, modernize, and homogenize regulatory requirements for 
federally chartered insurers. It would almost certainly achieve 
efficiencies in oversight and regulation of policy forms. The results 
would include helping to level the playing field between insurers and 
federally regulated financial institutions. Very importantly, federally 
chartered insurers would be substantially freed from antiquated and 
counter-productive prior approval rate regulation.
Participation in State Residual Markets and Guaranty Funds
    If federally chartered property/casualty insurers could be exempted 
from participation in State residual markets, residual market rate 
regulation could not be used to produce sustainable cross-subsidies 
among insurance buyers. States that wanted to cap rates for higher-risk 
buyers would have to finance rate subsidies some other way. Exemption, 
however, seems unlikely in view of legitimate State interests in 
ensuring the availability of mandatory coverages. In order to reduce 
the ability of States to use residual markets to cap property/casualty 
insurance rates (e.g., in automobile and workers' compensation 
insurance), the best approach (incorporated in S. 2509) is probably to 
make participation of federally chartered insurers in property/casualty 
residual markets contingent on rates being set at self-sustaining 
levels. To be sure, disputes as to whether that type of criterion is 
being met in some States are likely inevitable.
    A Federal guaranty system for federally chartered insurers would 
destabilize and eventually completely crowd out the State system. 
Requiring federally chartered insurers to participate in the State 
guaranty fund system, perhaps subject to some minimum standards, is 
sensible. S. 2509 would require federally chartered insurers to 
participate in ``qualified'' State guaranty associations and establish 
a national guaranty fund, with ex post assessments, for obligations of 
insurers doing business in any non-qualified States.
    The guaranty system under Federal chartering, however, would likely 
evolve toward nationalization or quasi-nationalization with uniform 
coverage. Insolvency of a multistate federally chartered insurer with 
different coverage limits in different States would very likely create 
strong pressure for uniform, national coverage. Insolvency of a number 
of State-chartered insurers would likely create similar pressure. Such 
an evolution very likely would be accompanied by some Federal oversight 
of the insolvency risk of State-chartered insurers (as is true for 
State-chartered banks with Federal deposit insurance).
    As I have emphasized in a number of my publications, any move 
toward optional Federal chartering involves a risk that the scope of 
government guarantees of insurers' obligations will ultimately 
increase, thus increasing moral hazard and producing pressure for 
stricter solvency standards. A fundamental goal of the guaranty system 
with optional Federal chartering should be to maintain reasonable 
coverage limits overall and to include significant restrictions on 
coverage for commercial insurance, at least for buyers with substantial 
net worth. The creation of a pre-funded, Federal system for all 
insurers should be avoided. It is highly unlikely that meaningfully 
risk-based charges for guaranty fund coverage would accompany pre-
funding, and pre-funding could dull some insurers' incentives to press 
for effective solvency regulation and standards.
Regulatory Competition
    Optional Federal chartering would presumably provide additional and 
immediate motivation for State regulators to modernize their systems. 
More generally, it could promote beneficial regulatory competition over 
time if insurers are able to switch charters and regulators at 
relatively low cost. Dual chartering of banks appears to have resulted 
in a certain degree of beneficial regulatory competition. However, the 
cost to multistate, federally chartered insurers to switch back to a 
State charter and return to State regulation in multiple States might 
be larger than in banking. If so, there is a greater risk that Federal 
chartering could become dominant and entrenched for larger, multistate 
insurers, reducing the scope of regulatory competition.
Substantial Elimination of Rate Regulation
    The substantial elimination of prior approval rate regulation 
should be the sine qua non for optional Federal chartering of property/
casualty insurers. Elimination of prior approval rate regulation for 
federally chartered property/casualty insurers would be very likely to 
constrain substantially prior approval of rates for State-chartered 
insurers as well. Again, however, there are inherent uncertainties, 
including the scope of federally chartered insurers' exemption from 
rate regulation that will be included in any bill that might be passed, 
and regarding whether any exemptions will persist. It is also uncertain 
whether Federal regulation would persistently resist temptation to 
redistribute wealth through restrictions on rate classification, 
guaranteed issue, and mandates. State regulation is largely unable to 
achieve cross-subsidies between States (or between lines of business 
within a State). While Federal regulators may be more resistant to 
local pressures that produce within-State cross subsidies, they may 
face similar pressures on a national level and significant pressure 
over time for adopting or endorsing policies that promote cross-
subsidies within and between States.
Other Approaches to Spurring Regulatory Modernization
    The case for insurance regulatory modernization through increased 
uniformity and substantial deregulation of rates and forms is 
overwhelming. Optional Federal chartering might go a long way toward 
achieving this result. But there are risks, and it would require 
substantial investment and costs in creating and maintaining a Federal 
regulatory agency. Potential unintended consequences, or mistaken 
policies in response to political pressure, would have national 
effects. Two alternatives to improve insurance regulation without 
creating a Federal regulator and which might entail less risk are: (1) 
Federal preemption of State regulations that do not meet minimum 
standards, and (2) allowing insurers to choose a State for primary 
regulation with authorization to operate nationwide primarily under the 
rules of that State.
Minimum Standards and Preemption
    The enactment of minimum Federal standards for and preemption of 
certain forms of regulation could help modernize insurance regulation 
without creating a true Federal regulator and associated bureaucracy. 
The potential effectiveness of this approach as a means to remedy the 
key problems of rate and form regulation is not clear. Prohibiting 
prior approval rate regulation, for example, by itself would not 
prevent regulators in some States from challenging rates based on 
allegations that they are excessive or unfairly discriminatory. The 
threat of such actions could contribute to a de facto prior approval 
environment. More generally, any ``minimum standards'' approach faces 
the difficulty of monitoring compliance. States that did not wish to 
comply would attempt to circumvent or evade the requirements.
    A draft proposal, The State Modernization and Regulatory 
Transparency Act (SMART), released by Representatives Oxley and Baker, 
would establish minimum and uniform Federal standards for numerous 
activities of State regulation, with Federal preemption of State laws 
and rules failing to meet such standards after specified periods. The 
complex proposal deals with regulation of insurer and producer 
licensing, market conduct, policy forms, rates, surplus lines, 
reinsurance, fraud, solvency oversight, receivership of insolvent 
insurers, and the viatical market. A ``State-National Insurance 
Coordination Partnership'' would be created to oversee rules, changes, 
and compliance.
    The proposal contains provisions designed to promote uniformity and 
provide for one-stop approval of policy forms, and to eliminate prior 
approval rate regulation for commercial property/casualty insurance 
(excepting medical malpractice insurance). The proposal's breadth and 
complexity increases the difficulty of enforcement and the likelihood 
of unintended consequences. A narrower and simpler standards/preemption 
approach would focus on policy forms, rates, and possibly mandates.
Primary State Regulation
    Another approach to spurring modernization without Federal 
regulation would be for the Congress to enact legislation that would 
allow insurers to choose a ``primary State'' for the purpose of rate, 
form, and possibly a number of other types of regulation and allow them 
to operate in all other States where they are licensed (``secondary 
States'') without having to meet the corresponding requirements in 
those States. The general concept has its roots in corporate law, where 
corporations choose a State in which to be chartered, with that State's 
laws governing the rights of management and shareholders throughout the 
country. The concept is to some extent reflected in Federal 
authorization of risk retention groups for certain types of property/
casualty insurance.
    The Health Care Choice Act, proposed by Representative Shadegg and 
Senator DeMint, adopts this approach for individual health insurance. 
Insurers would be subject primarily to regulation by the primary State, 
but they could operate in secondary States subject to primary State 
rules. The proposal includes a number of safeguards and minimum 
standards for primary State regulation regarding, for example, solvency 
regulation, guaranteed renewability of contracts, and independent 
review of disputed claims. The bill requires clear disclosure and 
warning to consumers that primary State regulation applies and that 
various secondary State regulations do not. The main purpose is to 
allow consumers in States with mandated benefits, guaranteed issue, 
and/or community rating rules that drive up the cost of individual 
health insurance coverage to have the opportunity to buy coverage not 
subject to those constraints. Many consumers would likely be able to 
obtain less costly coverage that is more closely related to their needs 
and ability to pay.
    More generally, the primary regulator approach could be an 
effective means of achieving substantial homogenization and 
streamlining of policy form regulation for all types of insurance--and 
of significantly constraining prior approval rate regulation--with 
relatively little Federal involvement. A common argument against this 
general approach is that it could lead to a ``race to the bottom.'' 
That risk is reduced significantly by would-be primary States' concerns 
with their own citizens' welfare and by buyers (and agents/brokers) 
concerns with their own welfare. I believe that this risk could be 
managed with well-designed minimum standards and clear disclosure. It 
also, for example, would not be necessary to rely mainly on the primary 
State for solvency oversight and/or market conduct regulation.
Conclusion
    Despite the existence of economically appropriate regulatory 
regimes in many States, certain aspects of State regulation--in 
particular the regulation of rates, rate classification, and policy 
forms in many States--appear beyond repair at the State level. Some 
form of Federal intervention is necessary for fundamental change.
    The central goals of regulatory modernization should be to provide 
one-stop approval or certification of policy forms, to have virtually 
all rates, rate classes, and covered benefits determined by competition 
rather than regulation, and to preserve and enhance private market 
incentives for safe and sound insurance. The key policy question is 
what form of Federal intervention has the best potential for achieving 
these goals given short- and long-run political dynamics and the risks 
of unintended consequences.
    Optional Federal chartering and regulation of insurers offers the 
potential to achieve more streamlined, less duplicative, and pro-
competitive regulation. A well-designed optional Federal chartering 
system would have a number of potential advantages. It would also 
entail the creation of a new Federal bureaucracy and inherent risks. 
The alternative of allowing insurers to designate a ``primary State'' 
and to operate nationwide subject in large part to the regulations of 
that State might have the potential to improve significantly the 
performance of insurance regulation with relative simplicity, less 
risk, and without creating a Federal regulator. A narrowly targeted 
program of minimum Federal standards that would preempt non-conforming 
State regulation also has the potential to improve insurance regulation 
without creating a Federal regulator, and perhaps also with less risk 
than Federal chartering.
                                 ______
                                 
              PREPARED STATEMENT OF ROBERT W. KLEIN, Ph.D.
   Director of the Center for Risk Management and Insurance Research
                        Georgia State University
                             July 18, 2006
Introduction and Summary
    Chairman Shelby and Members of the Committee, good afternoon and 
thank you for the opportunity to testify before the Committee on the 
topic of insurance regulation.
    My name is Robert Klein. I am currently the Director of the Center 
for Risk Management and Insurance and an Associate Professor of Risk 
Management and Insurance at Georgia State University. In my 30-year 
career I have been both an insurance regulator and an economist who has 
studied insurance regulation. From 1979 to 1988, I served as an 
economist for the Michigan Insurance Bureau and the Michigan Senate. 
From 1988 to 1996, I was the Chief Economist and Director of Research 
for the National Association of Insurance Commissioners. I joined the 
faculty and assumed my current positions at Georgia State University in 
1996. I have performed a number of studies and written numerous 
publications on topics in insurance regulation--a list of some of these 
publications appear as ``Selected References'' at the end of my written 
testimony.
    In my opinion, the States have come a long way in improving their 
regulation of insurance but further reforms are needed, both in terms 
of the States' structures/processes as well as their policies. I think 
the preferred institutional route to this goal is strong Federal 
standards for and oversight of the States' regulation of insurance that 
will move their structures and policies to where they need to be. In 
essence, the States need to appropriately and efficiently regulate 
things that need to be regulated and not regulate things that do not 
need to be regulated. If this cannot be achieved under the 
institutional arrangement I favor, then an optional Federal charter 
approach may be necessary to achieve the objectives that the States 
would be unwilling or unable to achieve.
    The specific reforms that I propose reflect four basic themes or 
characteristics:

  1.  The elimination of regulation where it is not needed;

  2.  uniform, appropriate and efficient regulation where it is needed 
        to the extent uniformity is possible given differences in State 
        laws that cannot be changed;

  3.  singular institutions and processes for insurer filings and 
        applications that would be approved for all States; and

  4.  full ``rationalization'' and coordination of all State 
        enforcement and compliance activities.

    The urgency and need for insurance regulatory reform is increasing 
for several reasons. One, risk and choice regarding health insurance 
and retirement funding is increasingly being shifted from employers to 
employees. Two, as the baby boom generation moves into retirement, 
their purchase of or choices regarding health insurance and retirement 
funding vehicles will affect a large segment of the population. 
Privatization of some portion of social security accounts could further 
increase the importance of this area. Third, environmental and 
political changes appear to be increasing the risk of natural and man-
made ``disasters'' so it is important that individuals and firms 
purchase sufficient insurance coverage at risk-based prices. Fourth, 
insurance companies continue to improve their financial risk management 
but this remains a continuing challenge because of mega or catastrophe 
risks, macroeconomic volatility, and the use of more complex and novel 
risk hedging/diversification instruments. Fifth, international trade in 
insurance is increasing and this has implications for the regulation of 
insurers entering U.S. markets as well as U.S. insurers that are 
seeking to enter foreign markets. Regulators need to keep pace with 
these developments and update their standards and enforcement 
activities accordingly. Regulators' resources will be stressed so they 
need to use their resources efficiently and shift their efforts to 
areas where regulation is most needed and away from areas where it is 
not needed.
    A key factor underlying my recommendations is the highly 
competitive nature of most insurance markets, despite widespread 
consumer ignorance about insurance. Enough consumers shop for the best 
price and pay some attention to quality of service that most insurers 
in most markets behave as if every consumer was well informed and 
shopped intensively. The main problem that arises and requires 
regulatory attention is the ability of insurers with ``improper 
intentions'' to take advantage of many consumers' ignorance or 
inability to understand what they are buying and to correctly determine 
the solidity and integrity of the insurers they are buying from. There 
is also a problem with certain specific lines of insurance, such as 
title insurance and credit insurance, where the nature of the sales 
process and relationships between lenders and insurers lead to 
``reverse'' competition problems. Hence, these specific lines require 
greater regulatory supervision than lines such as auto, home and life 
insurance.
    Further, in disputes between insurers and insureds over claims and 
benefits, insurers tend to have more bargaining power because of their 
substantial legal resources and ability to outlast an insured who is 
facing a financial crunch and has small reserves to draw from. Even 
nationally prominent insurers with strong brand names may seek to 
``push the envelope'' in certain situations or have particular 
employees who fail to act correctly. Hence, regulators can improve 
market performance in these areas by preventing insurers and personnel 
with bad intentions from taking unfair advantage of consumers either in 
the sale of insurance or in the payment of claims. Some of my 
colleagues may take issue with this opinion but there are literally 
thousands if not millions of examples of where market forces have 
failed to prevent abuses.\1\ Moreover, by going after the ``bad 
actors'', regulators make it easier for the ``good actors'' to do the 
right things and maintain a higher quality of service.
---------------------------------------------------------------------------
    \1\ The admitted misbehavior of several prominent life insurers and 
their agents in the 1980s involving the sale of universal life 
insurance products is just one of many of these examples.
---------------------------------------------------------------------------
    In the regulatory system I envision, the States would efficiently 
enforce a uniform set of regulations (to the extent uniformity is 
legally feasible) in their respective jurisdictions and the 
inefficiencies and costs of unnecessary State differences and redundant 
regulatory processes would be minimized. I recognize that the design 
and implementation of such a system would require substantial analysis 
and discussion to resolve a number of issues associated with combining 
collective and individual State enforcement of uniform regulations in 
the context of our Federal system of government in which the States 
retain certain prerogatives. Some form of Interstate Compact would 
probably be needed as one of the vehicles to create and implement the 
system as well as some sort of arrangement to monitor and audit States' 
enforcement activities. Such a system would also require a ``Plan B'' 
for States which chose not to join such a system. In the remainder of 
my testimony, I explain the nature and rationale for my proposed system 
and reforms in greater detail and address certain issues that might be 
raised and criticisms that might be made with respect to what I 
propose.
    I have one last partially self-serving observation to offer in this 
introduction. The ability of academics like me (at institutions that 
are not overwhelmed with donations and endowments from wealthy people 
and firms) to offer informed opinions on topics involving public policy 
and other matters dealing with risk and insurance is directly affected 
by public and private funding for ``basic'' research on the industry 
and its regulation. Unfortunately, both public and private funding of 
such research is almost non-existent and there are indications that it 
may totally evaporate. Further, academics' access to data and 
information resources, beyond publicly filed financial statement data, 
is becoming increasingly restricted and/or costly. The Congress and 
Administration could be of great help in taking steps to help with the 
funding problem and possibly with the data and information problem--
there would a relatively high return on the investment of a relatively 
small amount of funds (e.g., less than $1 million per year).
Summary of Proposed Reforms
    Among the specific reforms I would advocate are:

  1.  A uniform set of requirements should be adopted for insurance 
        products sold to persons, small businesses and for government-
        mandated insurance coverages (e.g., workers' compensation) to 
        the extent that uniformity is legally feasible.

  2.  Regulatory restrictions or mandates on the insurance products 
        sold to medium and large businesses should be eliminated except 
        where government requirements or significant externalities 
        compel such regulation.

  3.  Prospective price regulation should be eliminated in all lines of 
        insurance, except those lines where market failures and abuses 
        have been demonstrated such as in title insurance and credit 
        insurance. Some residual regulatory authority to intervene in 
        pricing should be retained should competition and market forces 
        fail to ensure fair and competitive rates.

  4.  A process should be established that would allow an insurer to 
        make one product filing that could be approved for sale in 
        multiple States as well as one licensing application that could 
        apply to multiple States.

  5.  A rigorous set of uniform financial standards should be 
        established, maintained and properly enforced--we are almost 
        there but have more ground to cover. Also, the laws and process 
        for administering insurance company receiverships should be 
        further rationalized and made uniform among the States.

  6.  There should be streamlined and appropriate State enforcement of 
        all insurance regulations that are retained or instituted, 
        including single, national financial and market conduct 
        examinations that would serve all States.

  7.  Efforts to streamline and nationalize the licensing and 
        regulation of insurance producers should continue to their 
        maximum possible fulfillment.

  8.  A comprehensive effort should be made to develop common and 
        uniform systems for reporting of various insurers data that 
        would minimize the cost of such reporting and maximize the 
        value of and access to the information reported with 
        appropriate protection of information that would be considered 
        unsuitable for public access.

  9.  Competent and qualified State insurance commissioners should be 
        appointed--not elected. No one would propose that Federal bank 
        regulators be elected and the same principles should apply to 
        State regulatory officials.

  10.  There should be a comprehensive and strengthened program of 
        consumer and public education and information regarding the 
        risks they must manage and related insurance products and 
        coverages--the high level of consumer and public ignorance and 
        misconceptions regarding insurance frustrates efforts to 
        improve insurance regulation.

  11.  There should be a comprehensive and continuing evaluation of 
        regulatory attention to chronic and emerging problems and the 
        effectiveness and efficiency of regulatory monitoring and 
        enforcement activities. An independent, national Insurance 
        Regulation Oversight Commission could be established to perform 
        this function and advise the Congress, working cooperatively 
        with the National Association of Insurance Commissioners and 
        other national organizations of State officials and 
        legislators.

    This is a long list of ideas but it is not exhaustive nor is it 
uncontroversial. There may be legitimate differences of opinion about 
their merits and feasibility. The list is intended to promote the kind 
of thought and discussion that will be needed to ultimately develop an 
optimal and feasible program of reforms. It is relatively easy to 
propose reforms; crafting a workable system within the web of States' 
rights and laws is another matter. Achieving sufficient political 
consensus and support and overcoming antagonistic special interests 
presents an additional challenge.

    I also recognize that the NAIC has initiatives in many of the areas 
of reform I have identified above. In some areas, these initiatives may 
eventually come close to achieving certain of the objectives I have 
advocated. However, for reasons I will explain below, in many areas the 
NAIC is not going as far as I would advocate or can only encourage but 
not force the States to make the necessary changes.
Alternative Institutional Structures: Federal and State Roles
    This leads me to comment further on the Federal versus State 
institutional debate since this is an issue that weighs heavily in 
peoples' minds even if this hearing is intended to address a broader 
set of issues. Further, the institutional structure that is employed 
has implications for the nature of the reforms that can be instituted. 
I prefer to discuss and dispense with this issue here so that I can 
move on to detailed discussion of the reforms I advocate.
    I will acknowledge that sweeping reforms could be accomplished 
through the complete takeover of insurance regulation by the Federal 
Government if it were to establish efficient processes and the 
``right'' policies, but there is no assurance that this would occur 
under Federal insurance regulation or that such processes and policies 
would be sustained over time. Hence, while Federal regulation might 
exploit certain inherent structural efficiencies and reforms would be 
easier to achieve from a legal standpoint, I am not convinced that it 
would necessarily result in better regulation and there is the danger 
that it could result in worse regulation.
    I also have some reservations about the optional Federal charter 
proposal, although it does have some merits and may ultimately be the 
only feasible way to achieve the reforms I advocate. I understand that 
it is viewed as having certain desirable properties--most notably, it 
is voluntary in the sense that insurers could choose to be federally or 
State regulated and consumers could choose to buy insurance from 
federally or State regulated insurers. Further, it would increase the 
efficiency and reduce the cost of regulatory compliance for insurers 
with national operations. Some of my colleagues may also favor the idea 
because they perceive that it would promote ``regulatory competition'' 
and they tend to view competition as a good force. However, in my view, 
competition between individuals and firms in markets for goods and 
services may yield efficiencies and benefits that do not always carry 
over to competition between governments.
    The crux of the problem is that the ultimate arbiters of what 
governments do and the companies that insurance is purchased from--
voters and consumers--are woefully ignorant about insurance and its 
regulation. I am concerned that many consumers would not understand or 
be able to evaluate the differences between and the implications of 
Federal versus State-regulated insurers or differences between the 
policies of the two regimes. Hence, more of the power and benefits of 
choosing the regulatory venue could tend to accrue to the regulated not 
to the intended beneficiaries of regulation. It could weaken the 
oversight of State-regulated insurers and encourage States to ease 
regulations in ways that would be desirable to insurers ``on the 
fence'' but not in the best interest of consumers.
    Further, it would probably lead to increased market concentration 
as federally chartered insurers would able to increase their 
competitive advantage over State-regulated insurers and State 
regulation would not be able to impose the entry barriers and high 
compliance costs that they currently do on national insurers. Increased 
concentration is generally viewed as a bad thing but this would not 
necessarily be the case if it derives from the increased efficiency of 
federally chartered insurers and the benefits of these efficiencies are 
passed to consumers. I would expect that concentration would not 
increase to a level that would impair competition and reduced entry and 
exit barriers would contribute to competition. Hence, I do not view the 
likely market restructuring results of Federal chartering to be a 
reason to oppose this approach. State and regional insurers would 
probably diminish and focus their operations to ``niche markets'' that 
would not be served by national insurers.
    There is the risk of fraudulent insurers slipping through the gaps 
between Federal and State regulation, taking advantage of the confusion 
and gullibility of many consumers and small business owners. These 
problems have been demonstrated in the Federal carve-out of ERISA-
qualified health insurance plans and the problems that have occurred 
with some risk retention and purchasing groups. One can imagine the 
frustrations and problems that would occur for a consumer with 
legitimate complaints about an insurer who contacts one regulator and 
is told that the insurer is regulated by another entity or perhaps not 
regulated at all.
    All of this said, the alternative institutional approach I favor 
may not prove to be workable in the process of designing it and 
negotiating its features between the Federal and State governments. If 
that proves to be the case, then the optional Federal charter approach 
may be the next best solution. It does have a number of attributes and 
it would enable consumers to choose to buy insurance from insurers that 
are not hobbled by inappropriate or unnecessary State regulatory 
restrictions and mandates.
    The approach that I would prefer arises from my belief that the 
high tension between the Federal and State governments over insurance 
regulation has had very positive effects. Vesting insurance regulatory 
authority unequivocally in one entity or the other potentially reduces 
its incentives to implement needed reforms and could decrease the 
transparency of its policies and practices. At various times in 
history, the States have made great strides in improving their 
regulation of insurance when Federal intervention or takeover is 
threatened. In this struggle, the Federal Government has a big hammer 
and the greatest power that also has increased over time as it has 
gained more allies. The States, with their remaining allies, have less 
countervailing power but enough to force a good and transparent debate. 
For reasons that I do not yet fully understand, the debates and 
legislative threats that occur during these periods seem to promote a 
healthy and transparent examination of insurance regulatory systems and 
policies and the States feel compelled to institute reforms that are 
generally good ones.
    However, there is a legitimate question as to whether the States 
would have the ability and desire to fully achieve the kinds of 
ultimate reforms that I and others advocate. Many States, if not all, 
believe that they should retain some prerogative to regulate their own 
markets as they see fit--``market regulation'' pertains to things such 
as prices, policy forms and market practices. For example, if public 
officials in a State believe that it should still regulate prices for 
personal lines insurance, then they may strongly resist any pressures 
to do otherwise. The NAIC can and has strongly encouraged States to 
reform and standardize their regulation of insurance markets, but it 
has no authority and generally little leverage to compel States to do 
so. The NAIC has also created systems to facilitate single portals for 
insurer/intermediary filings and applications, but the requirements for 
approval of what is filed and applied for still vary among States with 
exception of life and annuity products.
    In contrast, the NAIC is able to compel much greater uniformity and 
quality with respect to the financial or solvency regulation of 
insurance companies (which I distinguish from market regulation) 
because of the greater inter-connections between State polices and 
practices in this area.
    Only the threat of Federal intervention, either full takeover or 
optional chartering, can potentially induce all the States to move 
further toward uniformity and reform than they would otherwise choose 
to do so. Even then, certain States may draw a line in the sand, beyond 
which they are unwilling to go unless forced to by some higher 
authority. Hence, the issues of regulatory reforms and the question of 
the institutional structure that would be established by Congress are 
intertwined and not yet resolved. Congress would be wise to hold its 
cards until these issues and questions are resolved.
Detailed Discussion of Specific Reforms
    Below I attempt to explain and support my recommendations in 
greater detail. Unfortunately, given the short notice I received, time 
did not permit me to fully explain all of my recommendations so I have 
focused on those that I believe are the most important and likely to 
encounter the greatest controversy. I can further explain my ideas and 
respond to other questions in additional testimony submitted after 
today's hearing.
Regulation of Insurance Products
    The regulation of insurance products refers primarily to the policy 
forms that insurers must file for approval with State insurance 
departments before the policies can be used in the market. The term 
``product'' may be more appropriate because insurers may be required to 
file and receive approval for related materials such as marketing 
plans. Insurers are typically required to file for approval both new 
products and changes to existing products. Typically, the States 
require prior approval of products sold to persons and small business 
(e.g., auto insurance, home insurance, life insurance, business owners 
polices, etc.) or that are subject to State governmental mandates, such 
as workers' compensation insurance. The level or degree of regulation 
of products sold to medium size and larger firms tends to be less, 
especially in States that have embraced NAIC templates for the 
``reengineering'' of commercial lines regulation. These firms, with the 
assistance of informed risk managers and brokers, should be able to 
protect their own interests in assessing products and insurers and 
negotiating contract terms.
    For most property-casualty products that are more intensively 
regulated, State requirements and mandates for approval vary both 
formally (State laws and regulations) and informally (regulators' 
preferences with respect to policy language, policy form formats, 
etc.). Understandably, this greatly frustrates insurers seeking to sell 
similar products in multiple States and increases the cost of delays in 
the introduction of new products or product changes. I would be more 
sympathetic to the States' view on this if I accepted their argument 
that differences in State conditions justify differences in product 
requirements. However, with the exception of differences in the cost of 
living (it probably costs more to get a car repaired in New York than 
in Mississippi), I do not believe that differences in State needs 
justify the degree of variation in State requirements. Most of the 
variation, in my opinion, results from different political environments 
or philosophies, as well as the particular preferences of the insurance 
regulators that help make and interpret the rules. Hence, I believe 
that substantially greater uniformity and reduction of unnecessary or 
excessive requirements would substantially decrease transactions costs, 
would not harm the consumers in specific States, and would ultimately 
work to their benefit whether they realize it or not.
    The regulation of certain life insurance, annuity and health 
insurance products do warrant special discussion. Through the years, 
there have been periodic problems with the sale and representation of 
certain more complex life/annuity products, such as universal life 
policies, and variable life and variable annuity products, among 
others. Other products can be complex, such as Long Term Care (LTC) 
policies and hybrid life-LTC products. I discuss these issues and NAIC/
regulatory responses in greater detail in the second edition of the 
text I wrote for the NAIC--A Regulator's Introduction to the Insurance 
Industry (NAIC: 2005).
    I believe that these areas of product and market practice 
regulation will be particularly crucial in the years ahead as more 
households will need to consider the purchase of these products. I 
think effective and adequate regulation could be accomplished through 
uniform requirements among States as reflected in NAIC model laws, 
regulations and other guidelines but the requirements must be 
rigorously enforced and updated as products continue to evolve and new 
products and/or problems may emerge. Hence, regulation in this area may 
need to be strengthened, not necessarily in terms of the model 
requirements that the NAIC has developed, but in terms of the 
allocation of regulatory resources and the intensity of regulatory 
monitoring of compliance. Reducing or eliminating regulation in other 
areas where it is not needed could potentially make more resources 
available for the regulation of life, annuity and LTC products and 
practices. Certain other types of insurance products such as ``critical 
illness'' policies may also fall into this category.
    It appears that the NAIC and the States may be well on their way to 
achieving this objective with respect to life and annuity products with 
a singular filing process and uniform product requirements with the 
development of its InterState Insurance Product Regulation Compact 
(IIPRC) which I understand has 27 States signed on and anticipates 
becoming fully operational in early 2007. I have not had the 
opportunity to fully assess this mechanism nor evaluate any objections 
or criticisms by insurers or associations that do not believe that it 
is sufficient to address their concerns about the current system. There 
is also the question of how many additional States will be expected to 
join and how quickly they will do so. At a minimum, the Federal 
Government could encourage more States to join with the enactment of 
Federal standards.
Deregulation of Rates/Pricing
    Because of the highly competitive nature of most insurance markets 
(title and credit insurance being exceptions), prospective regulation 
of rates (e.g., prior approval of rates or rate changes) is 
unnecessary. Numerous studies of price regulation in auto and workers' 
compensation insurance effectively reveal no benefits but potentially 
severe problems from insurance rate regulation. For the most part, 
regulators are compelled to approve the same prices or rates that would 
otherwise be set by the market. It is also difficult to sustain cross-
subsidies through the manipulation of rate structures when low-risk 
consumers have choices about who they buy insurance from and/or how 
much insurance they buy. However, there are instances, some quite 
notorious, where regulators have sought to forestall or avoid economic 
reality by suppressing rates below adequate levels and/or substantially 
compressing rate structures (i.e., the rate differences between risk 
classes or geographic areas).
    Regulators can ``get away'' with modest rate suppression or 
compression for limited periods of time, but if they take it too far 
and too long, major market problems result. The amount of coverage that 
insurers are willing to supply voluntarily plummets far below what 
consumers need or want. Further, rate suppression/compression distorts 
insureds' incentives to control risk and losses. In its worst 
manifestation, severe rate suppression can result in the collapse of a 
market as occurred in the Maine workers' compensation insurance market 
in the early 1990s.
    Some might blame State insurance commissioners for such behavior 
but this is myopic. Most voters and consumers tend to harbor 
misconceptions about insurance rates and what is ultimately in their 
best interest and special interest groups can knowingly seek cross-
subsidies in their favor. The point is that a commissioner who seeks to 
approve adequate and actuarially fair rates when costs are escalating 
can encounter significant political opposition that will eventually 
remove him or her from office. Hence, the blame should lie with those 
who ultimately control the political fortunes of Governors, regulators 
and legislators.
    This contributes to the argument for rate deregulation. If 
regulators have no authority to approve or disapprove rates 
prospectively, then this should divert some of the political pressure 
that they would otherwise face. Of course, deregulation does not 
totally solve the problem if there is always the danger that voters or 
special interest groups can reinstitute rate regulation or legislate 
rate restrictions.\2\ Still, if Federal standards and interstate 
compacts make this less likely, then the potential danger and threat is 
reduced.
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    \2\ The passage of a popular referendum in California, Proposition 
103 in 1988, in which voters approved a mandatory 20-percent decrease 
in their premiums for auto insurance offers one of the most egregious 
examples of the misuse of political and democratic processes to attempt 
to manipulate the price of insurance.
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    It should be noted that market-based prices are not necessarily 
perfect or stable. Insurers can make pricing mistakes by failing to 
anticipate cost increases or decreases or accurately determine 
differences between risk classifications. However, such mistakes tend 
to be short-term in nature as markets tend to correct these mistakes 
fairly quickly. One example of this is that increases in homeowners 
insurance rates in the Midwest during 2001-2002 have stopped and rates 
are starting to come down in these areas. The situation for property 
insurance along the Gulf and East coasts is somewhat more complex and 
does not lend itself to simple explanations or predictions.
    There is another problem that can last somewhat longer. Certain 
commercial insurance markets in ``long-tail lines'' (i.e., lines where 
there can be a considerable lag between when premiums are set and 
collected and claims are fully paid) are subject to cyclical shifts in 
the supply and price of insurance--this is commonly known as the 
``underwriting cycle''. The cycle begins with a chronic ``soft market'' 
phase in which insurers tend to under-price the coverage they sell and 
overly relax their underwriting standards. Academics and practitioners 
continue to probe and debate why this occurs, but regardless of the 
causes the reality is that it happens. Ultimately, after insurers lose 
a lot of money and can no longer ignore their under-pricing, the supply 
of insurance tends to tighten sharply and prices can rise 
dramatically--this is called the ``hard market'' phase. Hard markets 
tend not to last too long (roughly 2 years at most unless claim costs 
continue to escalate) and once insurers begin earning positive profits 
the supply of insurance begins to increase and prices fall. Hence, the 
ultimate implications of this cyclical behavior is that commercial 
insurance buyers have to deal with some volatility in what they pay for 
insurance but over the long term they tend to get a price break because 
insurers' long-run profits tend to fall below what would be considered 
a fair rate of return.
    If rate regulation could mitigate this phenomenon it might provide 
a partial argument for retaining some regulatory control of pricing. 
However, the research indicates that rate regulation does not mitigate 
the cycle and may in fact worsen it because of lags between the filing 
and approval of rate changes. Also, in commercial lines, if insurers 
want to cut prices they have a number of ways to circumvent any 
regulatory attempts to stop them.\3\
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    \3\ The reality is that regulators rarely, if ever, try to stop 
them. Understandably, commercial insurance buyers would oppose any 
regulatory price floors and regulators see little value in taking on 
that fight.
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    The only strategy that regulators might employ is to take action 
against an insurer that is cutting prices to the point that its 
solvency is threatened. Unfortunately, Pennsylvania regulators failed 
to do this in the case of the Reliance Group until it dug a $2 billion 
hole that will be covered by consumers, taxpayers, other insurers and 
unpaid creditors. At the same time, firms that bought insurance from 
Reliance when it was obviously charging too little and spending too 
much conveniently ignored an inevitable reality.
    All of this discussion leads me to argue for rate deregulation for 
all lines (with the exceptions I noted). It does not seem to offer any 
benefits but it can cause a lot of problems. To help satisfy the 
skeptics and ensure adherence to the requirements of the McCarran-
Ferguson Act, regulators should monitor competition in insurance 
markets and retain some residual authority to intervene if competition 
should fail for some reason. This could be accomplished by requiring 
insurers to file rates for informational purposes, but not for approval 
either before or after their implementation. Further, if insurers' 
rates are not subject to approval, it would seem that there would no 
reason to require approval of the loss costs filed by advisory 
organizations.
    There are related issues with the administration and regulation of 
what are known generally as State ``residual market mechanisms''. These 
are mechanisms established by the States to provide coverage to people 
and firms that, in theory, cannot obtain coverage in the ``voluntary 
market''. They are typically found in auto, home and workers' 
compensation insurance and sometimes in medical malpractice insurance. 
If a residual mechanism is managed properly such that it applies 
stringent requirements for accepting applicants, charges adequate rates 
to cover its full costs, and rates in the voluntary markets are allowed 
to rise to adequate levels, then these mechanisms tend to remain small 
in volume and do impose a significant burden.\4\ However, if their 
rates are suppressed and the other conditions do not hold, then they 
can swell and begin to contribute to significant market problems and 
distortions. Hence, rate deregulation must be accompanied by 
responsible management of residual mechanisms in order for voluntary 
markets to work properly.
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    \4\ Occasionally residual mechanisms can swell during periods of 
significant market adjustments as is occurring for property insurance 
in coastal areas. However, they should depopulate fairly quickly if the 
market is allowed to adjust to a sustainable equilibrium and new 
capital is attracted to the market to help absorb consumers who 
temporarily could not obtain coverage in the voluntary market.
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Singular Product Filings and Licensing Applications
    The NAIC has sought to greatly improve the efficiency of insurer 
rate and form filings which provides a single point for filings that 
are not subject to the IIRPC--the System for Electronic Rate and Form 
Filing (SERFF). According to the NAIC's testimony, the system has grown 
dramatically with complete State participation and participation by a 
large number of insurers. While SERFF make filings easier, it does not 
fully solve the problems perceived by insurers who operate in a large 
number of States. Each State must ultimately approve or disapprove 
these filings according to its own laws, regulations and requirements. 
Hence, products must be modified for different States and their 
approval in a particular State may still be delayed.
    A truly ``singular'' process would allow an insurer to file one 
product that would be subject to review and approval by one entity that 
would automatically apply to all States or at least a large group of 
States. Of course, this is one of the major objectives of insurers 
supporting the optional Federal charter bill. In order for the States 
to replicate the same kind of process they would need to: 1) have 
uniform product and licensing requirements; and 2) entrust the review 
and approval of filings and application to a central entity. This would 
be a major step beyond where the States are currently moving. A number 
of States might object to taking this step because they would view it 
as a major abrogation of their individual regulatory authorities.
    However, as I have Stated earlier, I do not see a need for States 
to have differing regulatory requirements nor is it unprecedented for 
them to delegate their regulatory approvals to a central entity. Hence, 
in my view, it comes down to how far the States are willing to go in 
the institutional framework I propose versus the optional Federal 
charter approach. If the States would be unwilling to take this step, 
it would strengthen the case for an optional Federal charter.
    There is also the issue of company licensing applications. 
According Commissioner Iuppa's testimony for the NAIC, it has developed 
a Uniform Certificate of Authority Application (UCAA) that establishes 
the base forms for use in company licensing applications. An electronic 
system has been built to facilitate the expansion application and 
communication processes, making it easier for insurers to expand to 
other States. Commissioner Iuppa also Stated that the NAIC and the 
States have largely addressed the issue of State-specific requirements 
often cited by the industry and have provided transparency for the 
State-specific requirements that remain.
    While these developments are commendable, they stop short of a 
truly singular licensing application process that would allow an 
insurer to file one application and be approved for licensing in 
multiple States. Understandably, the States would like to retain their 
individual authorities to accept or reject license applications 
according to their standards and assessment of an insurer. I do not 
know how satisfied insurers are with the current state of affairs and 
their views of further streamlining the application process. It would 
not surprise me if a gap remains between what the States are willing to 
accommodate and what insurers would like to see. If that is the case, 
then it seems further progress could be made to ``unifying'' the 
application and approval process without admitting ``rouge insurers'' 
to quote Commissioner Iuppa. It comes down to how much farther the 
States are willing to go to concede some of their discretion on 
approving applications and how much farther insurers think the States 
should go to achieve an optimal balance of efficiency and regulatory 
protection.
Financial Regulation and Administration of Insurer Receiverships
    The States have made the greatest strides in the financial or 
solvency regulation of insurers. Because States' interests are more 
intertwined in the financial regulation of an insurer (because the 
financial regulation of an insurer by its domiciliary State affects the 
interests of all States in which the insurer does business) the NAIC 
has been able to go a lot farther in terms of getting the States to 
adopt and enforce strong and uniform standards, as well as engage in 
more cooperative efforts. Further improvements could be made but the 
States tend not to oppose uniformity in this area contrary to their 
views on market regulation.
    The reforms that have been instituted are beyond the scope of this 
testimony. My publications and Commissioner Iuppa's testimony discuss 
some of these initiatives. Commissioner Iuppa's testimony did not 
address requirements for ``dynamic financial analysis'' for property-
casualty (p-c) insurers consistent with what is occurring in the 
development of international insurer solvency standards. In my opinion, 
this is an important area for consideration and perhaps one of the 
remaining linchpins that could be incorporated into p-c insurers' 
financial requirements. However, it appears to be a highly 
controversial idea. Most large insurers already engage in this kind of 
analysis, but many p-c insurers, both large and small, may resist the 
notion of being compelled to perform this analysis and have it 
scrutinized by State insurance regulators. Life insurers are already 
more acquainted and comfortable with this kind of regulation because it 
has been tied historically to their asset-liability management.
    I believe that this is an issue on which the p-c insurers must 
eventually give in because it makes good sense despite their objections 
and it represents one of the final elements of a set of rigorous and 
appropriate financial requirements that have already been adopted in 
certain other countries with advanced regulatory systems. Of course, 
exactly what will be required is a legitimate issue for discussion and 
negotiation. Beyond that, the challenge for the States will be to have 
the personnel and infrastructure in place to properly evaluate the 
analyses that will be performed and submitted by insurers. Another 
issue will be how regulators use this information and how they will act 
when an insurer's analysis indicates the need for some form of 
regulatory attention or intervention.
    As with the regulation of market conduct, financial regulators must 
deal with a shifting landscape, new developments and threats, insurer 
practices and mega-events and catastrophes that could have sweeping 
effects on a number of insurers. It appears that the NAIC has tended to 
respond to new issues, albeit a little late, but the action or 
reactions of individual State regulators within existing standards or 
the revision of standards may occur with too long of lag. Spurring 
regulators to quicker action within existing standards may be something 
that could be accomplished through the strengthening of existing NAIC 
committees and mechanisms to coordinate State regulatory action. 
Revising standards is another matter because of the long deliberative 
process that is somewhat inherent to the NAIC's structure and lack of 
actual authority. It is not clear how this might be resolved unless 
some central entity would be given the authority to ``fast-track'' 
quickly needed changes in financial standards and requirements (such as 
that kind of authority that is vested with Federal financial regulatory 
agencies).
    For the most part, the number and severity of insurer failures is 
low but there are some exceptions such as Reliance. Why regulators did 
not act more quickly still remains unclear. It would be desirable to 
vest some entity with authority to conduct ``post-mortem'' 
investigations of certain insolvencies where there are legitimate 
questions either about the causes of the insolvency, or more 
importantly, the actions or the timing of actions by the responsible 
regulators.
    There is also the issue of how the receiverships of impaired or 
insolvent insurers are managed. After I and two of my colleagues 
submitted a critical report on this matter, the NAIC set forth an 
extensive and ambitious program of reforms that in part will be 
facilitated and endorsed by the NAIC but ultimately must be implemented 
by the States. While the reforms are ambitious considering this area 
has been subject to the greatest inertial resistance by certain vested 
interests, I still believe they may fall short in a couple of key 
respects. Most importantly, there must be effective oversight and 
control over appointed receivers and the domiciliary regulators of 
insurers in receivership to minimize waste and maximize efficiency. 
Second, full exploitation of alternative workout plans for impaired p-c 
insurers must be explored as an alternative to liquidations that 
typically result in higher ``deficits'' that eventually are paid by 
creditors, the ``public'' and others that bear little or no 
responsibility for the insolvency. Some policyholders and claimants are 
covered by guaranty associations that pass their net costs to other 
insurers, their insureds and taxpayers.
State Enforcement of Market Regulations
    Even with uniform requirements for and singular approval insurance 
products, there will still be a need for the States to monitor and 
enforce insurers' and intermediaries compliance with all State laws and 
regulations, uniform or not. I believe that this would best be done at 
the State level if the States can demonstrate that they can do this 
appropriately, effectively, and efficiently. State regulators are 
closest to the activities of insurers and intermediaries in their 
markets and it would be a costly and substantial enterprise to replace 
the compliance infrastructure that is already in place.
    The NAIC has pushed an agenda that would make ``market conduct'' 
regulation more efficient and effective, but its recommendations fall 
short of what I would advocate and we do not know yet whether the 
States will even implement what the NAIC recommends. Commissioner 
Iuppa's testimony cites some promising statistics but there is still a 
high mountain to climb in terms of achieving the level of efficiency 
that is possible and in the best interests of consumers and insurers.
    Based on studies and surveys I have conducted as well as others, it 
appears that a large number of States and market regulators still seem 
to be resistant to the kinds of reforms that are warranted. Some States 
and regulators seem to zealously defend their prerogative to regulate 
market conduct the way they think is appropriate, regardless of whether 
it conforms with NAIC or other national standards or recommended 
policies and procedures.
    State preferences can make a big difference in the costs and 
burdens of market conduct regulation for insurers with no evidence of a 
``return'' on these costs in terms of better market conduct or 
increased compliance. Some States insist on conducting their own market 
conduct exams of licensed insurers in their States that means that a 
given insurer can be subject to 5-10 market conduct exams by different 
States in a year that basically plow the same ground. Some States share 
information on their market conduct examinations with other States and 
others do not. Some States conduct exams relatively efficiently and 
others waste substantial regulatory and company resources. Some States 
recognize and consider self-compliance activities of companies and 
other States ignore them. Consequently, while I commend what the NAIC 
is trying to do and acknowledge that it has made some progress in 
reducing the amount of inefficiency, I reserve judgment on how much 
further progress it will be able to make with its current program and 
influence.
    If market conduct regulation is going to be really reformed in all 
States there will be a need to establish strong national standards and 
approved methods that the States will be compelled to implement. These 
standards and methods will need to be embodied in the vehicles that the 
Federal Government and the States will use to unify and rationalize 
other aspects of insurance regulation. I have co-authored reports and 
articles that outline a number of recommendations on market conduct 
regulation but there are three that I will mention here that should be 
included in any Federal standards. The first is that an insurer should 
be subject to only one routine or targeted market conduct examination 
that will serve all interested States. The second recommendation is 
that all States should be required to give some consideration to 
insurer self-compliance activities, whether performed individually or 
cooperatively through an industry self-regulatory organization. The 
third is that all States should be required to improve their monitoring 
and detection systems to better target their investigations to 
potentially significant and emerging problems and not toward massive 
error-finding scavenger hunts. In sum, all States should stop wasting 
resources on things that yield little value and focus their resources 
on serious problems that have the greatest impact on consumers.
Producer (Intermediary) Licensing and Regulation
    It appears that the NAIC has made some strides in facilitating more 
efficient licensing and appointment of insurance producers, especially 
those that wish to operate in multiple States. I have not had the 
opportunity to assess how much progress has been made in making this 
process more efficient but I suspect that some national agents and 
brokers are not satisfied by what has been accomplished so far. It 
appears that even though NAIC systems facilitate electronic 
applications to multiple States using a standardized form, the 
individuals States still set their own standards and make their own 
determinations as to who will be given a license.
    Recently, I had the opportunity to review a survey of State 
producer licensing and education requirements and it seemed that there 
was a significant amount of variation that was difficult for me to 
rationalize. Like insurance product requirements, it is not clear to me 
why producer standards should vary greatly by State. Further, I fear 
that some States' regulation of producers and their educational 
requirements are inadequate and instances of producer fraud and 
incompetence continue to abound. I would support the concept of a 
standardized but rigorous set of producer licensing requirements that 
would be closely enforced by the individuals States if they 
demonstrated the capability to do so. This would permit a producer to 
submit one application to be approved to do business in multiple States 
but the producer would be held to high standards that would help reduce 
the abuses and mistakes that continue to occur.
Other Recommendations
    Time does not permit me to explain the other recommendations I made 
in the introduction section of my testimony but I will offer two 
related opinions that I consider important. The first has to do with 
the data that are reported and maintained that allow legislators, 
regulators, researchers and others to monitor and analyze the insurance 
industry and its issues. Data from insurer financial statements is 
quite extensive and public access is relatively good so I do not view 
this as a problem area. The problem lies with other kinds of data that 
go beyond financial data in helping us understand how insurance markets 
are working and allow us to further probe issues such as cost trends, 
causes of increasing costs, pricing and underwriting issues, and a host 
of other important questions. Over time, public access to this kind of 
information has actually declined as statistical and advisory 
organizations have converted from non-profit organizations with a 
public mission to for-profit organizations with an essentially 
proprietary mission. Insurers are also more zealously guarding access 
to their data for proprietary reasons.
    As a researcher, I am finding it increasingly difficult to access 
data to conduct studies while the actual amount of data held by certain 
organizations has actually increased. We need to find some kind of 
balanced resolution of this problem that will facilitate better and 
more research while addressing insurers' proprietary and privacy 
concerns and the costs of collecting such data by the organizations 
that have it.
    The other serious problem that needs to be addressed is the 
tremendous amount of consumer and public ignorance about risk, 
insurance and regulation. The ability to rely on consumer choice and 
market forces rather than regulation is directly tied to consumers' 
knowledge and cost of acquiring information. There is probably a small 
segment of the population that read the articles by financial 
journalists and are relatively knowledgeable but I suspect there is 
much larger group of people who are badly uninformed or harbor many 
misconceptions. I personally encounter this ignorance in a variety of 
interactions with various people.
    Public and private organizations have undertaken extensive consumer 
education efforts but most people probably do not avail themselves of 
these services. We need to think about even greater proactive and 
aggressive public education efforts that reach more people and 
``encourage'' more of them to become informed. Ironically, we seem to 
accept such a notion when it comes to things like public health but not 
financial health which is just as important. Some of my colleagues may 
object to such efforts but we are paying a heavy price for consumer 
ignorance that will only increase as people are required to make more 
decisions. The claimed ignorance about the flood exclusions on 
homeowners insurance polices, the failure to save and prepare for 
retirement income needs, and the general misconceptions about what 
insurance is are exacting heavy tolls and make it harder for 
legislators and regulators to pursue economically sound policies. We 
cannot expect to get every consumer and voter to become well informed 
but we need to see if we can achieve a significant reduction in the 
level and breadth of ignorance.
Concluding Observations
    Clearly, there are a range of interests and different opinions on 
how insurance should be regulated and who should do it. I will not 
accuse any group of being insincere in the opinions they express, but 
to borrow a concept of one of my old professors, people tend to 
perceive the world in a way that best suits their interests. This does 
not mean any particular opinion is invalid, but every opinion including 
mine must be scrutinized and tested against a set of principles and 
valid facts. Ultimately, what matters is what is in the best interests 
of consumers and the general public and this is what the Congress has 
to determine.
    Designing a regulatory system and setting regulatory policies by 
necessity is a balancing act. The benefits and costs of relying on 
``free choice'' and market forces have to be balanced against the 
benefits and costs of regulatory constraints and mandates. The choice 
of an institutional framework also affects costs and effectiveness and 
may have implications for how incentive conflicts between different 
insurance market participants are resolved. I have offered my opinions 
on what I think insurance regulation should like but I do not claim to 
be omniscient or invulnerable to error. The important thing is that the 
Committee is facilitating a full airing of the issues and opinions that 
will allow it to make the most informed and best decisions that will 
serve the public interest. I would be happy to continue to engage in 
communications with the Committee and comment further on any questions 
it may have.
Selected References
Grace, Martin F., Robert W. Klein, and Richard D. Phillips, 2002, 
    ``Managing the Cost of Property-Casualty Insurer Insolvencies,'' 
    Report to the NAIC, December.
Hanson, Jon S., Robert E. Dineen, and Michael B. Johnson, 1974, 
    Monitoring Competition: A Means of Regulating the Property and 
    Liability Insurance Business (Milwaukee, Wisc.: NAIC).
Iuppa, Alessandro, 2006, ``Testimony Before the Senate Committee on 
    Banking Housing, and Urban Affairs: Regarding Insurance Regulation 
    Reform,'' July 11, Washington, D.C.
Klein, Robert W., 1995, Insurance Regulation in Transition, Journal of 
    Risk and Insurance, 62: 363-404.
Klein, Robert W., 2004, ``The Underwriting Cycle,'' Encyclopedia of 
    Actuarial Science, Jozef Teugels and Bjorn Sundt, eds. (Hoboken, 
    N.J.: John Wiley & Sons, Inc.).
Klein, Robert W., 2005, A Regulator's Introduction to the Insurance 
    Industry, 2nd Ed. (Kansas City, Mo.: NAIC).
National Association of Insurance Commissioners, 2005, 2005 Regulatory 
    Initiatives: Goals, Action Plans & Deadlines for States, Committees 
    & NAIC Staff (Kansas City, Mo.: NAIC).
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