Even if one discounts the calamitous months that ended the year preceding it, 2009 was already shaping up to be an eventful year for insurance companies. Long-standing regulatory disputes regarding issues such as agent licensing, and the establishment of an optional federal charter were already percolating. So it's not much of a stretch to assume that given the subsequent meltdown of the financial services market - and the proclivity of politicians to pass sweeping legislation in the wake of such events - that such issues will likely come to a full boil in 2009.

While insurance regulation has traditionally focused solely on solvency - the concern was that companies had the financial wherewithal to make good on claims - new regulations will likely take a more holistic, enterprisewide approach. In light of recent events, in addition to protecting consumers from misconduct by insurers, insurance regulators will now be charged with protecting insurers from themselves.

"I think we are absolutely going to see increased regulatory activity across the board," says Daniel Wright, VP and chief compliance officer for Jackson National Life Distributors, a subsidiary of Lansing, Mich.-based Jackson National Life. "The nature of the financial markets and the amount of turmoil that's existing there is going to necessitate some activity. Where exactly that's going to fall is going to be the challenge."

 REACTION AND OVERREACTION

Obviously, this impetus for action also carries the peril that the resulting legislation, conceived in haste, will have unintended consequences. This is the charge often leveled at the Sarbanes Oxley Act, which was passed in the wake of the Enron and World Com bankruptcies.

"[Congress] either does nothing or they overreact," says Jimi Grande, VP, federal affairs, for National Association of Mutual Insurance Cos. (NAMIC), adding that it's possible to streamline and improve the current insurance regulatory system without launching a complete overhaul.

Until the new Congress convenes, the legislative landscape is still subject to conjecture, as bills introduced in the previous Congress are reintroduced. What hasn't changed is the central cast of characters. House Financial Services Chairman Rep. Barney Frank (D.-Mass.) retains his seat, as does Rep. Paul Kanjorski (D.-Pa.) who introduced the Insurance Information Act (H.R. 5840), which calls to establish an Office of Insurance Information (OII) within the U.S. Treasury Department.

In the upper chamber, Sen. Chris Dodd (D.-Conn.) decided to retain the gavel of the Senate Banking Committee, instead of opting to replace Vice-president elect Joe Biden as chairman of Senate Foreign Relations Committee. The decision by Dodd, whose home state hosts many insurance entities, to stay put was welcomed. "Senator Dodd has a strong working knowledge of insurance and the insurance marketplace," says Marc Racicot, president of the American Insurance Association. "As Chair, we are confident he will continue to legislate in a way that provides the type of effective regulation that protects consumers, and ensures the safety and soundness of the insurance industry."

KNOWNS AND UNKNOWNS

While the legislative intentions of Dodd, Frank and Kanjorski are well known, the priorities of the incoming administration are less defined. As a candidate, President-elect Obama proposed requiring insurance companies to cover pre-existing conditions, establishing a national health insurance exchange, and lowering the cost of malpractice insurance.

However, the new administration has yet to articulate a grand plan for regulation of the insurance industry. This was not the case with the Bush Administration, which reignited the debate over an optional federal charter (OFC) in March when Treasury Secretary Henry Paulson released his sweeping blueprint for regulation of the financial services industry, which made an explicit appeal for an OFC.

Indeed, of all the legislative battles involving insurance, the efforts to establish an OFC is one of the longest running and most contentious. The anti-OFC camp includes associations such as NAMIC, the National Association of Insurance Commissioners (NAIC), the National Conference of Insurance Legislators (NCOIL) and the Independent Insurance Agents & Brokers of America, while OFC proponents include the American Insurance Association, American Council of Life Insurers and the Council of Insurance Agents & Brokers.

A greatly simplified analysis would hold that the issue splits the industry along the axis of size, with mostly large insurers expressing support for an OFC, and small and mid-sized carriers largely in opposition. Smaller carriers contend an OFC would put them at competitive disadvantage.

"It's not going to be an optional federal charter - it's going to be a mandatory federal charter," Grande says. "A lot of companies can handle more regulation. Well, guess what? A lot of them won't be able to."

Conversely, large insurers say it is they who are currently at a disadvantage in an increasingly global insurance marketplace, burdened by a redundant, federated system. "Our industry would operate much more efficiently without the constant changes to products, prices and practices foisted upon us by 50 separate state legislatures and 50 regulators," says John Degnan, vice chairman and COO of Warren, N.J.-based Chubb Corp.

OLD FAULT LINES

In addition to matters of size, the OFC also exposes a fault line over regulatory philosophy, pitting proponents of federal regulation against those who favor state-based insurance oversight. OFC backers, including Paulson, contend the global nature of insurance requires federal oversight and that the current patchwork of regulation and regulators is outdated and in need of modernization. OFC backers contend the law is a necessity to achieve uniformity and harmonization.

Opponents of a federal regulator say proponents of federal regulation are using the financial crisis for cover to advance an OFC after initiatives withered in previous legislative sessions. "We have to be very vigilant - more so than ever before - because there will be those that will use this financial crisis as an excuse for federal regulation of insurance," says New York State Senator James Seward, the incoming president of NCOIL.

Furthermore, opponents maintain the states have proven themselves more than capable of regulating insurers, and that uniformity, both national and international, is possible without a federal charter. To buttress this contention, they point to legislative initiatives such as the Insurance Information Act and the National Association of Registered Agents and Brokers Reform Act of 2008 (NARAB II), which would provide for non-resident insurance agent and broker licensing while preserving the rights of states to supervise and discipline insurance agents and brokers, as examples.

When introduced in March, some OFC opponents considered the Insurance Information Act, through its establishment of the OII, as a back-door attempt at establishing a federal presence in the insurance space. However, after changes were made in the bill to clarify that the role of the OII was to be advisory, not regulatory, the legislation did garner support from those vehemently opposed to an OFC, including the NAIC. "If it's done correctly, it could take away the need or some of the need for an optional Federal charter," Grande says.

Likewise, NARAB, which passed the House in September after being introduced by Reps. David Scott (D-Ga.) and Geoff Davis (R-Ky.), promises to standardize the fragmented licensing and appointment process. "A state may have a standard demographic form, but then many states will append that basic standard form with state-specific information or processes that they require," says Zach McCoy from Kaplan Compliance Solutions, Indianapolis.

THE IMPETUS

The calculus in everyone's political calculations changed in October with the implosion and subsequent bailout of New York-based American International Group (AIG). "The scope of insurance compliance has, in the case of AIG, proven to be inadequate," says Donald Light, senior analyst at Boston-based Celent. "What would be a public policy solution to that is much less clear."

AIG served as a multi-billion dollar Rorschach test, as both sides of the OFC debate interpreted the company's travails as evidence for their contentions. OFC opponents noted that the state-regulated businesses of AIG remained solvent, while it's federally regulated businesses ran into trouble.

"Their reasons for failure had absolutely nothing to do with the business of insurance, and everything to do with exotic financial tools, credit default swaps and things that were either federally regulated, or apparently not regulated at all," Grande says, noting that the vast scope of AIG's business makes it atypical even for a large insurance company. "It really doesn't look like most insurance companies."

Accordingly, Grande does not expect the next Congress to make drastic changes. "They're certainly not interested in giving companies the option of choosing their regulator, nor are they interested in any deregulation," he says. "Anything Congress does is likely to be additive to the current regulatory regime. They're not going to abolish state regulation of insurance."

Stephen Lowe, managing director of Towers Perrin's global property/casualty insurance practice, isn't so sure. Lowe predicts that a federal umbrella for all of financial services may be increasingly likely.

"It's not that state regulation is broken or that it failed us, because it didn't," he says. "But I do think as financial service companies broaden in multiple businesses, it's hard to have state regulation. Financial services cross sectors and cross borders. You can't keep having regulatory arbitrage between sectors or borders. It's a bit of stretch for the New York Insurance Department to assert authority globally for credit default swaps."

Even New York Insurance Superintendent Eric Dinallo, who had advocated plans for state insurance commissioners to regulate the credit default swap market in September, concedes this point. Dinallo backed away from the idea when testifying before Congress in November. Although he still deemed the swaps a legitimate part of an insurer regulator's purview, Dinallo said having multiple regulators oversee the heretofore-unregulated market was impractical, and that he now preferred a broader, federal regulatory plan.

THE FRAMEWORK

It is precisely this interrelation between insurance and other financial service divisions within an insurer that meaningful legislation must address, Light says. "In a very broad sense nothing has changed, but what has become screamingly obvious is that the ways that regulators match assets to liabilities and investment income has not been adequate," he continues. "If you're an insurance regulator, the question becomes: Should you extend your reach to non-insurance related parts of a holding company? That's a much harder question."

The answer to that question may well resemble European Union's Solvency II requirements, which have been under development since 2004, and are set to be enacted in 2011. The requirements mandate strict governance and risk management practices for insurers, and require them to document their modeling process. Capital requirements are driven by how embedded risk management is in organizations.

While not perfect, Lowe believes the Solvency II requirements are a good template for U.S. lawmakers, and preferable to starting with a blank sheet.

"I think the U.S. regulatory bodies will move quickly to adopt something like Solvency II as a regulatory framework," Lowe says. "The Solvency II model is well thought out. The Europeans have been working on it for many years, and I think we'll see that model adopted in the United States."

Yet, this move was not always a certainty. "If the financial crisis had not happened, it's not clear that U.S. regulation would move toward Solvency II," Light says, noting the push toward a greater focus on risk management is under way irrespective of legislation. "Insurance companies themselves, pushed and prodded by rating agencies, will be doing a lot of stuff in 2009 to have better modeling capabilities, and to look at solvency under a variety of scenarios. Since the rating agencies are sort of de facto regulators, it's all the same thing."

The move toward harmonization with international standards is not limited to solvency concerns or insurance as the Securities and Exchange Commission is moving toward adopting international accounting standards. Moreover, the London-based International Accounting Standards Board (IASB), and the Norwalk, Conn.-based Financial Accounting Standards Board (FASB), have announced a joint approach to dealing with reporting issues arising from the global financial crisis.

Karen Pauli

RISE OF RISK MANAGEMENT

Much as SOX gained notoriety as a full employment act for CPAs, any new regulations arising from the current turmoil will likely have a salubrious effect on actuaries and the field of risk management.

"I do think that this crisis will be an impetus for companies to more fully implement risk management," Lowe says. "They will continue to get pressure from rating agencies."

Likewise, Karen Pauli, research director in the insurance practice at Needham, Mass.-based TowerGroup Inc., cautions that carriers cannot wait to get clarity of vision into their data. "When these regulations are promulgated, it is going to be a very short implementation time," she says. "So carriers must start now getting their houses in order."

Light says that, largely, the risk management tools insurers have at their disposal are sufficient, but that insurers need to have the right people, and to employ the tools in the right way.

"You can have the best modeling tools in and the world and have a skillful modeler, but if you put in the wrong assumptions, wrong scenarios or interpret the results in the wrong way, you're not ahead of the game," he says. "Large companies have large actuarial staffs. However, when you get to mid-sized companies, they may have a few actuaries, but their skill set may be more toward pricing and reserving, not enterprise financial modeling."

Indeed, Light says institutional knowledge is especially critical in such times when compiling models. Events once thought highly improbable, representing the thin tails on a bell curve, are occurring with greater frequency.

"We're in a thick tail," Light says. "It has become a wisdom issue as opposed to being able to shove in a lot of parameters into a model and see what comes out."

THE BATTLE AHEAD

It remains to be seen whether this move toward risk management is voluntary or a forced march. With a public anxious to pillory financial market wrongdoers, and a Congress inclined to do something, the expectations for action are high.

"There's enough blame to go around for the mess we're in, but no certainty of what to fix," Light says. "One can only hope that it's an intelligent discussion to take place in the regulatory arena."

Pauli foresees the tenor of the discussion being more confrontational than conversational. "What we're faced with here is very polarized, opposing opinions among some very powerful groups and people," she says. "Now, every regulator and legislator in D.C. has a strong opinion on this. It's going to be a titanic power struggle."

Jackson's Wright concurs that from a legislative standpoint, the only certainty in the coming year will be further uncertainty. "Until we have some details - or at least proposed details - it's pretty much a wait and see," he says. "I think that it is going to be pretty interesting over the next 12 to 24 months."

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