August 3, 2006
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Remarks of David G. Nason
Deputy Assistant Secretary, Financial Institutions Policy
U.S. Department of the Treasury

Before the National Organization of Life and Health Insurance
Guaranty Associations

Baltimore, MD - Thank you for that kind introduction Charlie.  It is a real pleasure for me to be here today.  I appreciate the opportunity to be back together to talk about insurance issues and about what is generally happening at the Treasury.

These are interesting and fascinating times to be at the Treasury Department.  As you know, we have a newly-minted Secretary – Henry "Hank" Paulson.  I can report that the Department is buzzing with excitement and enthusiasm about out new leader.  Secretary Paulson is extremely energetic and he has high expectations for the Department going forward.  We are very fortunate that he heeded the call to public service and I very much look forward to working with him to ensure that the U.S. financial system remains the most competitive in the world.

Treasury is spending more time studying insurance regulation and the insurance marketplace than it has in the past.  Some of this is required – Congress gave us the responsibility to implement and manage the Terrorism Risk Insurance Program, and some of it is simply because we at Treasury recognize that insurance plays a critical and growing role in our financial marketplace. 

I would like to use my time here today to talk about a few things.  First, from my initial meeting with Charlie to now, I can report that I have learned much about the state-based guaranty system and its many merits and benefits.  Second, I want to share with you some of Treasury's most recent thinking about modernization of the insurance regulatory system.  Lastly, I want to talk briefly about terrorism insurance.

Role of State Guaranty System

As Treasury considers the various approaches to modernization of insurance regulation, one thing is clear -- the state guaranty fund system has worked well as a mechanism to protect our nation's insurance consumers.

As a devout believer in our free-market system, I recognize that insolvencies in the insurance business like in any other businesses are a fact of life.  Not surprisingly, the historical causes of insurance company insolvencies vary greatly.  Common causes have included incompetent management, outright fraud, bad investments, or the mismatching of assets to insurance liabilities.  These factors are not unique to insurance, of course, but, like other "safety net" businesses, insurance insolvencies are viewed differently by some.  This was not always the case, however.  For a very long time, policyholders of failed insurance companies were largely left without real recourse, with no independent protection mechanism.

It was not until the 1960s where our citizenry made the decision that it was unacceptable to leave policyholders unprotected, and the notion of "insuring insurance" through state guaranty funds began to spread.  In 1969, the National Association of Insurance Commissioners (NAIC) adopted a Post-Assessment Property and Liability Insurance Guaranty Association Model Act, and in 1970 adopted a similar model act for the life and health industry.  The guaranty fund movement was spurred in the 1980s by a tidal wave of insurance insolvencies, but it was not until 1992 that all states, the District of Columbia and Puerto Rico enacted guaranty fund legislation for life/health insurance companies.

Since that time, guaranty funds have been able to react under crisis conditions to events of insolvency, and have constantly reinvented themselves to fulfill their mission.  The guaranty fund system withstood the Baldwin-United Corporation bankruptcy and its resulting effects.  These events, of course, were the reasons that NOLHGA was created (under the auspices of the ACLI).  At this point, it was clear that the specter of any large, multistate insolvency could create an untenable situation with individual state guaranty funds operating independently of one another. 

The real test for the system came in 1991 – generally referred to as the "year from hell" for the guaranty fund system.  There were 23 new multi-state insolvencies that year – an all-time record.  However, the system met the challenges through creativity and was able to put together coordinated rehabilitation plans for three major life insurance companies: Executive Life, Guarantee Security Life, and Mutual Benefit Life.  These events spurred legislative proposals supporting the creation of a federal guaranty system and complete federal preemption of insurance regulation.

For a variety of reasons, these proposals failed and the state guaranty system survived.  Because of the good work of your organizations, the state guaranty fund system has continued to develop and mature.

You are probably wondering why I chose to spend a few minutes summarizing the history of the state guaranty system at a conference hosted by a state-guaranty association.  The reason is simple.  While there are passionate views on virtually all aspects of the modernization debate – the viability and merit of the state guaranty system is rarely, if ever, called into question.  This is important for Treasury to recognize as we continue to think about the complex issues in and around insurance regulation.

Insurance Regulatory Modernization

As most of you know, Treasury recently provided some views on insurance regulatory modernization in testimony before the Senate Banking Committee.  As the Administration's principal voice on financial markets and financial institutions issues, Treasury pointed out that 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.  Indeed, 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. 

As we all know, 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.  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 structure of its system of regulation.

The regulatory system for the insurance industry should be consistent with the efficient and cost-effective provision of its services, and there appears to be virtually no disagreement that the current insurance regulatory system needs to be modernized.

Treasury has been closely monitoring the developments of the various approaches to modernizing insurance regulation – ranging from the self-initiated approaches of state regulators and the NAIC; the establishment of federal standards for the harmonization of state insurance rules (the SMART Act, or a more modest incremental approach as reflected in a recent House bill which is limited to surplus lines and reinsurance); or the establishment of an optional federal charter (OFC) embodied in Senators Sununu and Johnson's bill, the National Insurance Act of 2006.  While Treasury has not made a decision as to which approach would be most appropriate, everyone seems to agree that a thorough review is in order.  We are in the process of that evaluation now.

As we examine approaches to modernizing insurance regulation, two of the main issues that Treasury is focusing on are:

• Potential economic inefficiency, resulting both from the substance of regulation (such as price controls), but also from its structure (multiple non-uniform regulatory regimes); and
  
  
• International impediments, both questions of comity (facilitating international firms' operations in the US) and competitiveness (facilitating US firms' operations abroad).  

At the most fundamental level, the question posed in each of these areas is whether our current state-based system of insurance regulation is up to the task of meeting the challenges of today's evolving and increasingly global insurance market. 

It makes sense that the Treasury would focus some of its attention on potential inefficiencies created by price controls.  If a mandated price is set above a market clearing price, the result will be surpluses.  If a mandated price is set below a 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 risk, and thus be less likely to suffer additional insured losses.

One of the key aspects of inefficiency associated with price controls is reduced competition.  Price controls might seem to benefit consumers by keeping insurance costs low and states have developed a system of residual markets to address shortages when prices are suppressed below market clearing levels.  However, under residual market structures where insurers within a particular state share in the costs associated with providing coverage in the residual market, as the size of the residual market grows the number of insurers willing to undertake business within a given state may decrease.  A reduction in the number of insurance companies operating within a particular state lessens competition and innovation, which in turn impacts the efficiency of the market.

We, mostly through the efforts of our colleagues in International Affairs, are also focusing on the global consequences of our current insurance regulatory system.  While all insurance companies that are licensed to operate in the U.S. are subject to the same regulatory standards, foreign firms likely find adapting to such standards more difficult.  From the international perspective, foreign officials have noted during bilateral financial regulatory discussions 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.

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.  We must acknowledge some of the good work the NAIC is doing to attempt to address these issues.  The NAIC engages in regulatory cooperation with international insurance regulators and through Memoranda of Understanding, 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 U.S. 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. 

And, although it has not been the primary focus of our attention, as we consider these issues, we have to understand fully and appreciate how the state guaranty funds will be affected by the various proposals.  This is a very complex issue that requires significant attention.  Both the SMART Act and the Senate OFC approach maintain the current state guaranty fund system, but each takes different approaches.  

The SMART Act has an entire title devoted to the receivership of insurance companies.  The state guaranty fund system appears to be "built-in" to the SMART Act, which defines a "guaranty association" as "an insurance guaranty fund or association or any similar entity now or hereinafter created by state statute to pay, continue, or otherwise assure payment of, in whole or in part, the contractual claim obligations of impaired or insolvent insurers or health maintenance organizations."  It is our understanding that this approach seems workable but further refinements might be necessary such as requiring more coordination and cooperation among regulators, receivers, and guaranty funds. 

The Senate's OFC approach is quite different.  It requires that an insurer that opts for a federal charter must become and continue to be a member of the state guaranty funds in each "qualified" state in which it does business.  In order to be "qualified," a state must have a guaranty fund based on the NAIC models for guaranty funds.  If a national insurer were to do business in a "non-qualified" state, then that insurer would have to become a member of the National Insurance Guaranty Corporation (NIGC).  This concept of triggering a NIGC is similar to the approach taken in the Gramm-Leach Bliley Act, which provided for the triggering of the National Association of Registered Agents and Brokers if states did not accomplish a required degree of reciprocity in the licensing of agents.  The NIGC is an effort to require the states to adopt the NAIC models without technically preempting state law. 

These are not easy issues and, as we go forward with our analysis, we would appreciate your assistance.  Like our overall position on insurance regulatory modernization, we do not have a particular view on which guaranty fund approach is best.  Whatever option is ultimately pursued, care should be taken not to disrupt something that is working efficiently for the benefit of consumers.

To sum up, it is clear to us, and 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 cost and reduces the supply of insurance products to consumers.  It may deter international participation in our domestic markets and creates obstacles to our own insurance firms' international expansion.    These are all important issues that we look forward to working on in the coming months and years.

Terrorism Risk Insurance

Now let me turn another key insurance issue – terrorism risk insurance.  Following the significant economic dislocation that occurred in the wake of the September 11 attacks, the President and Congress acted by passing the Terrorism Risk Insurance Act of 2002, known as "TRIA."  TRIA ensured the continued widespread availability and affordability of commercial property and casualty terrorism coverage by basically placing the government in the reinsurance business.   

In June of last year, Treasury delivered to Congress its report on the effectiveness of TRIA.  Treasury concluded that TRIA had been effective in achieving its fundamental goal of enhancing the availability and affordability of commercial property and casualty terrorism risk insurance, including allowing time for rebuilding the capacity of the private sector. 

The Administration laid out its key principles before it would accept any extension of TRIA.  These were:

• a temporary extension
• encourage the private insurance market to develop innovative solutions and build capacity, and
•  reduce exposure to taxpayers. 

Congress acted, and on December 22, 2005, President Bush signed into law an extension of TRIA.   The extension addressed many of the necessary changes sought by the Administration:  the extension of the Program was limited to two-years (now expires on December 31, 2007); insurer retentions were increased to encourage greater private sector participation (both through higher deductibles and increased co-payments); and certain lines of insurance where the private sector appears capable of managing terrorism risk were removed from the Program. 

A provision in the TRIA extension requires an analysis by the President's Working Group on Financial Markets (PWG) regarding the long-term availability and affordability of terrorism insurance, including group life coverage and coverage for chemical, nuclear, biological, and radiological events.  The PWG's report is due to Congress by September 30 of this year.

There is or was some confusion about whether the PWG was created solely to write this report.  The PWG was created by executive order by President Reagan in 1988 in response to the 1987 stock market crash.  Following the issuance of its report in 1988 and follow-up work in 1991, the Working Group became largely inactive until 1994 when, at the urging of Congress and others, it was reactivated by the Secretary of the Treasury.  Since that time, it has met on a regular basis.  The PWG is chaired by the Secretary of the Treasury and includes the chairs of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. 

For the report on terrorism insurance, the PWG is required to consult with the NAIC, industry and policyholder stakeholders.  As a means of meeting this consultation requirement in the most efficient and most transparent manner, and given the short time frame to complete the report, Treasury, as chair of the PWG, published a Notice in the Federal Register seeking comments concerning the long-term availability of terrorism risk insurance.  The Notice asked a number of specific questions targeted at key factors such as reinsurance availability, modeling improvements, pricing decisions, and the interaction with state regulations.  Some specific examples of the questions we asked include:

• In the long-term, what are the key factors that will determine the amount of private-market insurer and reinsurer capacity available for terrorism risk insurance coverage and how will this evolve in the long-term?
•  What improvements have taken place in the ability of insurers to price terrorism risk insurance, including the development and use of modeling?
• To what extent have alternate risk transfer methods (e.g., catastrophe bonds or other capital market instruments) been used for terrorism risk insurance, and what is the potential for the long-term development of these products?
• Have state approaches made coverage more or less available and affordable, such as through permitted exclusions and rate regulation?  To what extent will the long-term availability and affordability of terrorism risk insurance be influenced by state insurance regulation?   

The nature of these questions should indicate the importance of the PWG's task.  Especially given our limited timeframe, this is not an easy analysis to perform.  We received about 40 detailed responses to our Notice.  The responses have proved very useful as the PWG moves forward.  In addition, we have been responsive to calls for additional outreach.  The PWG has also met with insurance regulators, policyholder groups, insurers, reinsurers, modelers, and other governmental agencies to gather further information.  We look forward to completing our work on this important issue and reporting our findings to Congress within the statutory timeframe.  At Treasury, we recognize that there will be ample debate going forward about the proper role, if any, for the federal government in the terrorism insurance marketplace. 

As you can see, we have a lot on our plate at the Treasury Department.  These are exciting times to be here and I am thankful for the opportunity to serve.  Thank you for having me here today, and I would be happy to take a few questions.

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