The Riskiest Business
Under attack by the feds, the insurance companies they regulate and the consumers they're supposed to protect, state insurance commissioners are running out of friends.
He set up dummy corporations and Swiss bank accounts. He used a Rolodex's worth of aliases. For nine years during the 1990s, Martin Frankel looted $200 million from insurance companies he owned and whose funds he was supposed to be investing. When Frankel absconded with his ill-gotten gains, the international manhunt for him became one of the biggest financial stories of 1999.
In an effort to figure out how he'd been able to get away with a crime that was so huge and affected insurance carriers in at least five different states, the U.S. Congress asked the General Accounting Office to investigate. The GAO's report, issued last fall, pointed its finger at the system that regulates insurers all across the country: the 51 insurance commissioners in the states and the District of Columbia. Weaknesses in some insurance departments, as well as at the National Association of Insurance Commissioners, had, the report said, allowed Frankel's activities to go undetected for nearly a decade. "We observed repeated instances of inadequate tools, policies, procedures and practices," the federal analysts wrote, "as well as a lack of information-sharing among different regulators, within and outside the insurance industry."
The need for tightening state oversight could not have been stated more clearly, yet there was really only one response the state insurance departments could give to the GAO: Take a number.
State insurance commissioners are under fire from every direction at the moment. Washington is intrigued with the idea of junking the entire structure of state insurance oversight and switching to a federal regulatory system. Powerful companies see state regulation as slow and antiquated. The Frankel case tarnished their record as guardians of the public good, as did lawsuits that reveal questionable practices by insurers that regulators had nothing to do with uncovering. Meanwhile, they are scrambling to respond to changes in the industry wrought by globalization and the passage in 1999 of the federal Financial Services Modernization Act, which broke down legal barriers between banking, securities and insurance. And they are trying to balance all these pressures while grappling with inadequate resources and state legislatures that seem, at times, intent on undercutting them.
Insurance has never been a superstar in state capitals, even though it is one of the three great financial industries in this country, along with banking and securities. That low profile is likely to change this year. For starters, the insurance commissioners will be spending the year wrestling with the question of just what the 150- year-old system of insurance regulation should look like in the future. On top of that, they face a crucial test: Can they adapt to industry pressures without sacrificing consumer protection and still maintain a regulatory system worthy of the name?
This is not an academic question for state legislators and other state officials. If insurance commissioners don't meet industry's needs, pressure is likely to mount in Washington for a federal substitute. But insurance companies pay roughly $10.2 billion to the states in premium taxes and fees, while the states spend only $839 million on insurance regulatory budgets; the difference goes right into state budgets, so losing insurance oversight to the federal government would mean losing that stream of revenue. Yet creating a system that is too solicitous of insurers will legitimately raise questions about the states' taste for policing the industry and undermine the rationale that state regulators routinely use to buttress the case for state oversight: They are closer to consumers and therefore can serve them better. At the moment, state insurance commissioners are on a political tightrope, working without a net.
To understand why the state regulatory system is under attack, it helps to know that its existence is an accident of geography, not the result of some long-ago stroke of policy insight. The first true consumer insurance advocate in the country, says Joseph Belth, professor emeritus of insurance at Indiana University, was a Boston mathematician named Elizur Wright, who in the mid-19th century successfully pressed the Massachusetts legislature to set some standards for how insurance companies could operate; New York soon followed suit, and then other states. "I'm convinced," says Belth, "that had he lived in Baltimore, or somewhere close to Washington, we would have had national regulation."
Be that as it may, by the time of the Civil War insurance companies operating nationally were finding it quite cumbersome to cater to the different demands of each state, and eventually backed a lawsuit in Virginia challenging state regulation on the grounds that it interfered with interstate commerce. In 1868, however, the U.S. Supreme Court ruled that insurance was not commerce, and in periodic decisions for the next 75 years reiterated that position. "The effect of these decisions," says Thomas Baker, who runs the Insurance Law Center at the University of Connecticut, "was to allow the states to continue to regulate, which was a pro-consumer position, given that we didn't have a real federal government until the Progressive Era and the New Deal."
This judicial protection ended in 1944, when the Supreme Court changed its mind and declared that insurance was commerce after all. For the first time in generations, states' oversight of the industry came under direct attack, but now it had a new and important ally: Insurers had become so accustomed to dealing with a multitude of regulators that they flocked to the states' defense. They besieged Congress, which the following year responded with the McCarran- Ferguson Act, essentially giving legislative sanction to the status quo. The law also, in effect, made the state regulatory system subject to congressional sufferance.
And so, in the mid-1980s, when the industry was shaken by the failures of several large insurance companies, no one should have been surprised when Michigan Democrat John Dingell, then the powerful chairman of the House Commerce Committee, began questioning whether state regulators were really capable of overseeing the industry. He drew up plans to create a federal agency modeled on the Securities and Exchange Commission. Again, the industry came to the defense of state regulators; leery of a new federal bureaucracy, it backed a move by the NAIC to beef up state oversight of companies' solvency and so undercut the rationale for a federal alternative. The commissioners built up a centralized financial database, to which companies in all states are required to submit annual statements, and they launched an accreditation program designed to pressure legislatures at least to fund a minimum level of staffing for their insurance departments.
Now, state oversight is again under scrutiny, only this time there's a difference: Insurers are no longer united in their preference for it. That shift stems in large part from the 1999 financial modernization law, known familiarly as Gramm-Leach-Bliley. The measure was a massive overhaul of federal laws governing financial institutions, and in particular it took away the barriers keeping banks or securities firms from competing directly with insurers. This means that bank holding companies, which are federally regulated, can now set up subsidiaries to sell insurance, and that life insurers selling annuities are competing more directly than ever with mutual funds and banks for a piece of policyholders' investment income. "Insurance people are worried in the long run that the divisions will break down so that insurance companies will need to get products to market fast," says UConn's Baker. " If they can't do it as fast as mutual funds or banks, they'll lose customers."
This is where the differences between the state regulation of insurance and the one-stop shopping possible under federal regulation of banks and securities firms become important. Life insurers in particular, says Jose Montemayor, Texas' insurance commissioner, "have to compete with bank-like products that are for retirement and asset accumulation. But while the banks are out there rolling out a product that will send your kids to college and your wife to Europe on vacation, insurers are still back here at the state capital trying to get approved."
Not surprisingly, some big life insurance companies look at the federal chartering system for banks, take note of the fact that the Office of the Comptroller of the Currency--which oversees new banking products--is often helpful to the industry, and wonder why they can't have that, too. Meanwhile, the American Bankers Association Insurance Association--yes, it really exists--isn't waiting: It has already proposed a federal chartering system for insurance. The measure's prospects this year in Congress are uncertain, but the chairman of the new Financial Services committee in the House, Republican Michael Oxley of Ohio, signaled last year that Congress might be open to the general idea. Across the aisle, Dingell has certainly suggested his interest. "If state regulators cannot do the job insurance consumers deserve and require," he said last year, "new regulatory mechanisms must be put in place that will."
State regulators have hardly been oblivious to the pressure. For the past year, the commissioners, working through the NAIC, have been on a crash course to modernize the system, and in particular to allay the industry's discontent with the states' lack of uniformity on regulatory approaches. Their thinking is simple: No matter what form it takes, state regulation of insurance is better than federal regulation. "A number of regulators recognize that there are facets of the state system that are somewhat arcane, costly and better suited to the 1950s than to the 21st century," says Kathleen Sebelius, Kansas' insurance commissioner and the new president of the NAIC. "But the heart of the system, which involves consumer protection and solvency regulation, stands up well compared to any federal system, so we feel there is some urgency in revamping the state system, getting rid of redundancies and slowdowns, and making it into a 21st-century process."
Some of this work was explicitly required by Gramm-Leach-Bliley. In particular, that measure includes a clause requiring that at least 29 states adopt a uniform method for licensing insurance agents by November 12, 2002, or a federal system will go into effect. To avoid this, an NAIC working group has proposed that states give their insurance commissioners the authority to adopt the uniform standards and procedures necessary for each state to participate in a centralized license registry.
The larger insurance companies clearly would benefit from something of the sort, simply for efficiency's sake: It is cumbersome for agents who work for a national company to have to pass 51 different licensing exams. So far, though, only a handful of states have acted. The reason is that the issues, though apparently simple, go straight to the heart of state sovereignty over insurance regulation. "I'm still not sure what happens if Michigan says you can be an insurance agent if you can sign your name with your eyes shut, and New York says you've got to take a three-year course," says Alexander "Pete" Grannis, a Manhattan Democrat who chairs the insurance committee in the New York State Assembly. "And what happens if someone screws up--if we cancel a Michigan guy's license to practice here for malpractice, does that mean Michigan can retaliate and cancel a New Yorker's right to practice there?"
Agent licensing may be one of the more straightforward challenges. Gramm-Leach-Bliley also pressures state commissioners to adopt standard regulations governing the privacy of consumers' health and financial information. The law did not set out especially stringent guidelines, and insurance companies, not surprisingly, were hoping that the NAIC would follow suit. Instead, Sebelius led an NAIC effort that goes further in protecting the privacy of consumers' health data than many insurers would like.
Another area in which the NAIC has moved forward is in its so-called "speed to market" work. Most states require their regulators to clear insurance companies' rates and "forms"--that is, the actual contracts that companies sell to consumers. But the need to pass muster with a swarm of different insurance regulators feeds many insurers' competitive fears. And so the heart of the NAIC's approach is to pursue a new, centralized system that would allow insurers looking to sell a product in more than one state to file their rates and forms once, with a Coordinated Advertising, Rate and Form Review Authority (CARFRA) set up under the NAIC's auspices.
CARFRA will get a limited, 10-state launch this spring, and so far will apply only to life and health insurers. A review panel made up of staff from each of the 10 states will issue an advisory recommendation in each case that comes before it; the affected state regulators can then opt to conduct their own up-front reviews within 45 days. "What we're proposing," says Frank Fitzgerald, Michigan's insurance commissioner, who along with Diane Koken of Pennsylvania oversaw CARFRA's development, "is a system that is more coordinated and nationalized than it is today, without it coming from Washington."
Even this simple rollout, though, has been fraught with political difficulties. On the one hand, the property and casualty insurers have signaled their discomfort with any move to boost the NAIC's role in insurance regulation. "As you give the NAIC more authority itself, or give it to some entity created by the NAIC," says Jack Ramirez, president of the National Association of Independent Insurers, the lead trade organization for property and casualty insurers, "you raise some serious questions of accountability. The NAIC is a trade association, so it's very unclear what its authority would be, or how you would challenge it."
At the same time, consumer advocates who worked with the NAIC on CARFRA are also quite frustrated. They pushed hard to have some sort of consumer representative sitting on the CARFRA review panel, and were rebuffed. The reason, says Fitzgerald, is that the commissioners wanted to create a process that could be implemented simply by administrative order. Arguing that what consumer representatives are really calling for is a change in law, he says, "We need proposals that can be acted on now, not proposals that will take two or three or five years to work through legislatures."
This hardly leaves consumer representatives happy. Bob Hunter, who served for a time as Texas' insurance commissioner and now is the Consumer Federation of America's point man on insurance issues, points out that when CARFRA was unveiled, Koken--who worked for insurance giant Provident Mutual before becoming a commissioner--was asked how consumers and their representatives might find out about the details of an insurance company's proposal. She responded that they could go to an insurance commissioner's public viewing room. "No one thought, `Wait, they're getting everything done in a central facility, and we've got to run around to 50 states to see what's going on?'" says Hunter. "That's the kind of thing that makes us really sick."
Moreover, says Eugene Anderson, a prominent New York lawyer who represents policyholders in actions against insurance companies, it is "the most outrageous fantasy I can imagine" to suggest that consumers' interests are first and foremost in state regulators' sights. "Take the oversight on premiums, which is very ineffective," he says. "A few years ago, automobile insurance was the single most profitable line of insurance in the United States. That's because the insurance companies have got the facilities to provide the regulators with double-talk and fuzzy math, and there are no consumer groups on a statewide level that have the resources to fight them."
Consumer advocates are also wary about where the NAIC may be headed with new "market-conduct" proposals. This is where regulators are supposed to have teeth--the ability to review how insurance products are sold, how well companies comply with the terms of their policies, and so on. Some of what the working group on market conduct appears to be contemplating is unexceptional: minimum standards for a state's market-conduct program, including what laws states ought to have on their books; what minimal qualifications state insurance auditors should have. But they are also eyeing ways of working with companies that do "self-audits," and how those might fit into a broader effort by regulators to keep track of what's taking place in the market. In order to encourage companies to reveal what they find on their own to regulators, says Steve Larsen, Maryland's insurance commissioner and chairman of the market-conduct working group, the commissioners are considering ways to ensure the confidentiality of that corporate information.
To understand why all this is worrisome to consumer advocates, you have to know that the effectiveness of state regulators in policing market conduct has hardly been the stuff of legend. There was the problem with "vanishing premium" life insurance policies, for instance, in which companies were accused of misleading policyholders with optimistic projections of returns on their policies; the most recent class-action settlement in such a case came in December, when Principal Life Insurance Co. of Des Moines agreed to pay $374 million to settle it. There's the legal challenge to the use of so-called "non-OEM" replacement parts required by some auto insurers--that is, their demand that repair shops use automobile parts not made by the original equipment manufacturer, which consumer advocates charge tend to be substandard; in 1999, a jury in southern Illinois awarded $456 million to State Farm policyholders, and the judge went on to issue a $730 million judgment against the insurer for consumer fraud. There have been repeated charges of life-insurance "churning," in which companies allegedly induce policyholders to replace existing policies with new policies, with commissions going to the companies' agents even while policyholders are led to believe that the change is taking place at no cost to them. And, of course, there are the revelations that some companies for decades used race in determining policyholders' premiums, charging higher rates to minorities.
These practices did not become public and were not challenged legally because of anything state regulators did. "The public attention to them came from lawyers," says Birny Birnbaum, who runs the Center for Economic Justice in Austin, Texas, which represents low-income consumers before administrative agencies in Texas and other states. "They were in effect for decades and regulators never identified the problems." Making the results of companies' internal investigations confidential--and so, potentially, not discoverable in class-action lawsuits--would remove what Birnbaum and others consider the most effective tool out there for enforcing consumers' rights.
Larsen, though, insists that this is not his intention. "We are looking for ways to do not just our own financial exams, but to leverage some of the work that companies do on their own and to create an environment in which they're willing to share some of that information with us," he says. It is not his group's goal, he adds, to create a barrier to anyone obtaining information through private litigation.
In the meantime, Sebelius says that this year the organization will pay more attention to consumer concerns. Consumer advocates, she says, "have some validity in saying to us, `You reformed the market side, you really need to reform the consumer side.' I agree, we need more common databases, more information, stronger and more uniform standards for market-conduct examinations."
Beyond such efforts, Sebelius believes that the states at least have an infrastructure with regard to market conduct. She points out that every state has a Web site and a consumer complaint division that responds to people who have complaints. "What's in place is considerably better than any federal response," she says.
Yet it's also unclear how far the NAIC can go in becoming an organization capable of helping the various state commissioners step up their market-conduct investigations. It tried this once before, back in the early 1990s, using the database of insurance company filings it had beefed up in the 1980s to look more closely at industry behavior and, in particular, to begin investigating redlining--that is, the illegal refusal to sell insurance to people living or working in poor or minority neighborhoods. Industry executives, in a move detailed by the Wall Street Journal in 1998, organized what amounted to a boycott of the NAIC--which depended on fees paid by the industry for most of its budget--and the organization backed down.
It remains true that a significant portion of the insurance industry feels most comfortable with a decentralized, state-level regulatory system and sees it as the best way to create competitive markets. Insurers also see it as more responsive to local factors. "Insurance markets, especially in property/casualty insurance, are local in nature--they vary from place to place depending on the weather, traffic congestion, population density and so on," says Jack Ramirez of the National Association of Independent Insurers. "We think that state regulation is more responsive to those local needs and variances."
But the question is on the table now, and as the University of Connecticut's Thomas Baker says, "It's not clear anymore that because regulators are geographically closer to my house, that they'll be able to take better care of my interests. What comes to mind is the old thing insurance industry people say: `Why do you want state regulation? Because 50 monkeys are better than one gorilla.'"