The Cost of Duplicative Regulation: Evidence From Risk Retention Groups

ABSTRACT A vast majority of insurers are regulated by each state in which they conduct business; however, a small subset of specialized firms, risk retention groups (RRGs), are largely exempt from most aspects of duplicative regulation no matter how many states they operate. This article analyzes the differences between RRGs and standard insurers specializing in commercial liability insurance to determine the cost of duplicative regulation. The costs associated with multi-state regulation are significantly higher than those for single-entity regulation. These high regulatory compliance costs reduce the technical efficiency of firms, deter firms from operating in additional states, and increase the price of insurance. INTRODUCTION More than 60 years after the McCarran-Ferguson Act the issue of state versus federal regulation of the insurance industry continues to be debated both within the industry and academia. (1) Under the current state regulatory system, insurers must obtain a license for each state they do business. Multi-state insurers face multiple regulatory bodies and multiple sets of regulations with which they must comply. The central complaint against state regulation is the inefficiencies inherent in complying with multiple regulators and regulations. The cost of duplicative regulation is frequently cited as the principal reason to change the way insurers are regulated. This study empirically evaluates the cost of duplicative regulation. The Federal Liability Risk Retention Act (LLRA) of 1986 created a system under which certain qualified firms, known as risk retention groups (RRGs), can conduct business nationwide under the authority of a single license. To qualify as a RRG, the firm must be an insurance entity composed of owners or members of an association connected by similar business practices and encountering similar liability exposures. RRGs are confined to assuming and spreading the common commercial liability exposures of the RRGs members (employers liability is excluded). The owners of the RRG must be members of the RRG and must be provided with liability insurance by the RRG. The day-to-day regulation of RRGs is controlled by the firm's chartering state and nondomiciliary states are largely exempt from regulating them. (2) The intent of the LLRA was to remove unnecessary regulation by states in which the RRG is not domiciled, while at the same time acknowledging the states' role in regulating insurance. The preemption of state regulation for RRGs provides an innovative setting to analyze the cost of multi-jurisdictional insurance regulation. The primary objective of this article is to quantify the cost differences between single-and multi-jurisdictional regulation. Born and Boyer (2011) argue that of the various types of ownership structures in the U.S. insurance market RRGs have the lowest risk-bearing capacity because of the absence of an internal capital market and the low diversification of their risk portfolio. Accordingly, Born, Boyer, and Barth (2009) suggest that the only advantage of being an RRG over a state-incorporated standard insurer must come from the absence of duplicative regulation rather than the financial and/or economic aspects of the business. The empirical strategy in this article is to compare RRGs to a group of standard insurers that incorporate in the same time period and operate in the same lines of business as RRGs to determine the cost of duplicative regulation. The RRG form serves as a proxy for a regulatory environment in which duplicative state regulatory barriers are substantially reduced (Born, Boyer, and Barth, 2009). Three issues regarding regulation and its impact on insurance firms are examined: (1) the size of regulatory compliance costs, (2) the impact of these compliance costs on firm operational efficiency, and (3) the per unit price of insurance. For firms operating in one state, and subject to regulation by one state, there is no significant difference in the regulatory compliance costs of RRGs and standard insurers. …