Just two years ago, American International Group’s brand name was worth an astonishing $7.49 billion dollars. This was just the intrinsic value of its brand, not counting its trillion-dollar portfolio (by comparison, Tiger Woods’s name is “only” worth $21 million). Today AIG’s brand name is tarnished and invokes associations with greed, foolishness, and failure.

Most Americans are aware of the collapse of AIG and the destruction it left in its path. Yet few Americans are cognizant of the fact that AIG’s insurance arm was not overseen by a single federal regulator. In fact, the only form of federal oversight came from the Office of Thrift Supervision (OTS), which was strictly limited to AIG’s financial and investment divisions. As a result, AIG had nearly 71 separate insurance operations, spread out across the nation. New York oversaw the largest group of units, and even that was only ten operations.

Given the fragmented nature of regulation, much of AIG’s risks were condensed in its financial products division, AIGFP. Through its credit-default-swap (CDS) portfolio, AIGFP lost billions for the company—almost equivalent to the gross national product of France. When AIGFP went broke, the parent company of AIG had to post more collateral, leading to insolvency and an eventual government rescue.

Many have suggested that had there been a federal regulator overseeing the combined financial and insurance entities of AIG, such a massive default would have been prevented. Under current regulatory law, a financial institution is allowed to designate itself as a “thrift” institution and thus fall under OTS jurisdiction. In fact, AIG—which has been a savings and loan holding company since 1999—purposefully exploited a regulatory gap under OTS, since OTS had no jurisdiction over AIG’s billion-dollar CDS holdings. As a result, AIG operated in a culture of regulatory arbitrage, where their financial arm squirmed away from regulators and gambled on the future of the entire company.

As the system exists today, many of the state regulations overlap one another and create costly burdens for insurance providers.

In the words of Eric Dinallo, superintendent of the New York Insurance Department, “when you permit companies to pick their regulator . . . you create the opportunity for a financial institution to select its regulator based on who might be more lenient, who might have less strict rules, who might demand less capital.”

Congress is now considering creating a national insurance regulator that would overhaul the current state-based regulatory system and prevent another AIG-like situation. The proposed legislation would create a National Insurance Agency (NIA), most likely housed within the Department of Treasury. Directed by a Commissioner of National Insurance, NIA would have preemptive power over states to coordinate insurance regulations for all insurance products, including life, automobile, homeowners, and liability insurance.

As Congress weighs the benefits of a new federal insurance regulator, it is worthwhile to pause and consider the weaknesses of the current system, and whether a new regime would effectively fill that gap.

What Is Wrong with the Status Quo?

As the system exists today, many of the state regulations overlap one another and create costly burdens for insurance providers. This type of redundant licensing regime can act as a barrier of entry for smaller insurance providers. Research by Martin Grace at Georgia State University and Hal Scott at Harvard Law University finds that a “federal insurance regulator could lower regulatory costs through more uniform and consistent chartering, licensing, and financial reporting requirements” and lead to a more diverse market.

Cost-saving measures are an important step towards opening up the insurance market to more competition. In a recent study, Laureen Regan of Temple University found the average life insurance agent has nine separate insurance licenses. Likewise, a study by the National Association of Insurance Commissioners (NAIC) found that the average health and life insurance companies maintain 25 separate state licenses. These licenses are not only redundant, they are expensive.

Additionally, the current state-based model magnifies asymmetric information among the issuer, the policy holder, and regulators. Just as if food safety were managed from state to state, one could imagine that the consumer and regulators would have a hard time overseeing all the activities of the uber-insurance companies domiciled in their state.

What is the likelihood that a new insurance regulator would overstep the boundaries of effective regulation?

State-by-state regulations can also slow down product development. If an insurance provider has to wait for separate approval from each state for a new coverage plan or annuity, the lag time may deter innovation and force individuals to turn to alternative means for protecting themselves against risk.

The Downfalls of a Federal Regulator

Upon closer reflection, a number of issues are likely to arise if we move from the status quo to a federal regulator. First and foremost, we would be turning over more power to Congress, which would the have free reign to impose a costly Sarbanes-Oxley-like regime over the insurance industry. What is the likelihood that this new insurance regulator would overstep the boundaries of effective regulation?

Furthermore, insurance licensing is an important source of revenue for states. For example, in fiscal 2007 California collected nearly $2.2 billion in taxes and $200 million in registration fees and licenses from domiciled insurance companies. States collect an annual total of $17.5 billion from taxes and fees, with nearly 92 percent going back to the state general funds. For states in budgetary hot water—such as California—depriving them of this additional source of revenue would hit them hard.

If an insurance provider has to wait for separate approval from each state for a new coverage plan or annuity, the lag time may deter innovation.

On the consumer side, policy holders may face an uphill battle for grievance complaints and filings. Although one side of the argument contends that a federal regulator would likely increase the effectiveness of fraud prevention and mediation, a federal regulator may require more time to address individual complaints.

It is important to note that most of the insurance agencies have done relatively well compared to the weakness in the banking industry. In fact, the regulatory capital requirements have been sufficient to protect them against massive insurance failures. Additionally, advocates for the state-based system have said that having “multiple eyes” overseeing the system is in fact more effective than any federal regulator could be.

A Look to the Future

Many have argued AIG was an aberration, and that the insurance regulatory model is not broken. Perhaps the next step should be to begin with a more modest set of reforms.

Recently, Representative Paul Kanjorski (D-Pennsylvania) introduced the Insurance Information Act of 2009, which would create a national information agency that would monitor risk and issue reports on conflicting state regulations and needed areas of reform. Opponents of the legislation have argued that this new agency would lack the coercive power to compel states to coordinate their insurance regulations and that we need a stronger regulatory body. Advocates have suggested this legislation would bring transparency to the market and improve consumer protection.

Alternative plans include creating a prudential regulator, like the Federal Deposit Insurance Corporation, that collects a premium from insurance providers and has the ability to “unwind” insolvent firms. Unlike the proposed federal regulator, this FDIC-like regulator would not supersede state regulatory power.

Such legislation, combined with a Kanjorski-style insurance information agency, could help combat regulatory overkill while improving information flow and minimizing moral hazard. Whatever the best step forward, Congress must act with prudence in ensuring a smart regulatory regime that prevents another AIG catastrophe, without inundating the system with superfluous regulations.

Emily Renwick is a research assistant at the American Enterprise Institute.

FURTHER READING: Renwick coauthored “Mark of the Beast,” on how it is time to follow President Franklin Delano Roosevelt and suspend mark-to-market, with AEI senior fellow and former Speaker of the House Newt Gingrich.

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