Financial reform gives insurance a free ride

June 21, 2010

The following is a guest post by Marc Levinson, a  senior fellow for international business at the Council on Foreign Relations. The following opinions expressed are his own.

In a critical area of the financial reform bill that’s about to pass, Congress has lost its nerve. As senators and representatives met Tuesday to agree on key details of the final bill, they voted to give the insurance industry a free ride – and did so in the name of consumer protection.

The conventional wisdom, much promoted on Capitol Hill, is that insurance was the shining star as a crisis wracked the financial sector in 2007 and 2008. Tough state regulation is said to have kept insurers robust as banks tottered, leaving no reason for federal intervention.

Unfortunately, this picture is far from true.  The subprime crisis exposed poorly regulated insurers as major sources of risk, transmitting problems from one part of the financial sector to another.

Financial experts, as well as state regulators, have long insisted that insurance cannot give rise to systemic risk. Insurance policyholders, the reasoning goes, cannot line up to demand cash if a company runs into trouble. Unlike a bank, an insurer’s obligations are long-term, which is said to give regulators plenty of time to deal with problems and make sure consumers’ claims are paid.

When the crisis struck in 2007, however, the luxury of time proved to be an illusion. Instead, insurers helped spread the crisis in at least two ways.

One involved obscure companies known as bond insurers, which had provided guarantees against the default of some securities created from subprime mortgages. As increasing numbers of homeowners stopped making mortgage payments, some of the insured securities defaulted, dealing losses to the bond insurers.

By late 2007, investors in the $2.6 trillion municipal-bond market sniffed trouble. Municipal bonds had nothing in common with subprime securities save the fact that some companies insured both types of instruments. The municipals market seized up as investors struggled to sort out the good risks from the bad. Mom-and-pop investors who owned ultra-conservative insured municipal bonds found themselves stuck with securities they could not sell.

The other state regulatory failure involved securities lending. Insurers frequently earn spare change by lending out their securities. The borrower, often a bank, puts up cash collateral worth more than the market value of the securities, giving the insurer extra money to invest. However, insurance companies owned by giant American International Group lent out their securities against collateral worth less than their value; the AIG holding company guaranteed that the individual insurance companies would get their money back. This obligation, which state regulators should never have permitted, left AIG short of cash to deal with the huge losses in its derivatives portfolio. The 2008 federal bailout of AIG included $43.8 billion to disentangle this reckless securities lending.

Nothing in the financial regulation bill will keep these problems from recurring. The reason: state officials who regulate the industry don’t want Uncle Sam on their turf.

Rep. Paul Kanjorski, the Pennsylvania Democrat who has been most concerned about insurance proposes to address these issues by creating a Federal Insurance Office. The office would negotiate an international agreement on regulating the soundness of insurance companies and could overrule state rules that conflict with that agreement. Kanjorski’s plan offers a back-door way of addressing the gaping holes in state insurance regulation, an issue Congress is very reluctant to take on. But, it would provide a politically practical means of addressing the systemic problems the states have ignored.

By the time House and Senate negotiators finished exchanging proposals on Tuesday afternoon, it seemed likely that the proposed Federal Insurance Office would have minimal power to push for tighter regulation. Consumer watchdogs, such as the Public Interest Research Group and Trade Watch, who entered the fray, contended that a federal role would weaken regulations that protect insurance consumers.

State regulators, in general, do a great job of overseeing life insurance and making sure that auto insurance claims are paid promptly. No one proposes to change that role. But the events of 2007 and 2008 demonstrate that state regulators lack the ability and the information to control the systemic risks arising from financial insurance.

Over the next week or two, the conference committee will have one more chance to bolster the Federal Insurance Office’s powers. Unless it does so, the holes in insurance regulation that contributed to the last crisis will contribute to the next one.

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