The Dodd-Frank Act and the insurance industry: Strategic considerations of U.S. financial reform
On July 21, President Obama signed into law the Wall Street Reform and Consumer Protection Act, often referred to as the Dodd-Frank Act. The far-reaching legislation contains a great many provisions affecting the banking industry but gives relatively little attention to the insurance industry, and that mostly in one section of the act. Title V spells out the two major areas of change: the creation of a Federal Insurance Office (FIO) within the Department of the Treasury, and state-based insurance reform, which applies mainly to reinsurance and nonadmitted insurance (surplus lines insurance).1
Since the enactment of the new law, many have commented that the insurance industry has been spared the stringent new provisions now being applied to banking. Nevertheless, the changes that pertain to insurance are significant because they represent a first step toward the potential transfer of regulatory authority from the states, the exclusive locus of regulatory authority until now, to the federal government.
What does this mean for the insurance industry? What are the strategic implications going forward?
Beginnings of federal oversight: Creation of the Federal Insurance Office
The Dodd-Frank Act does not remove the responsibility of regulating insurance from the states, but several provisions do represent a step toward federal oversight. The immediately visible product of the reform act is the creation of the FIO. The FIO will collect information and monitor all lines of insurance except health insurance, long-term care insurance, and crop insurance.
FIO director's report to Congress. Of particular importance is the mandate for the director of the FIO to submit a report to Congress within 18 months assessing the current state regulatory system and recommending improvements to the regulation of insurance in the United States. This report will cover a wide-ranging set of issues, including systemic risk regulation, capital standards, consumer protection, international coordination of insurance regulation, and a sweeping inquiry into the feasibility and potential costs and benefits of regulating insurance at the federal level and/or sharing such regulation between the states and the federal government. 2
The director's report could be of great consequence to the insurance industry. Its recommendations could determine the disposition of insurance regulation for many years to come.
State vs. federal regulation. For a long time, people inside and outside of the industry have debated the merits of maintaining the current state-based regulatory system versus moving to federal regulation. 3 Those who argue for keeping control in the hands of state governments take the "If it ain’t broke, don't fix it" approach; they point out that the system has evolved over many years, and it works. The insurance industry survived the recent financial crisis in far better shape than the banking industry. To shift the regulatory authority to the federal government, whether completely or partially, would impose high transition costs; and if the new system were to involve a shared authority between state and federal bodies, the result would complicate the environment by adding a new layer of regulations and ongoing costs. In the end, these proponents say, it would not serve the interests of our free-market system for the federal government to step further into this enormous sector of the economy.
Those who favor a major regulatory role for the federal government, on the other hand, criticize the fragmentation of the state-centered system. They point out that a great many insurance companies do business across the entire United States, which means they must conform to the laws of all 50 states plus the District of Columbia. It's cumbersome when introducing a new product, and it's costly at all times because the industry must employ many people to keep track of the regulations and manage business across the 51 separate environments. As the new law stands, the FIO has the power to pre-empt the authority of the states in issues involving international agreements. In addition, proponents argue that, in an increasingly globalized insurance market, a federal-level authority is needed to standardize the rules for foreign-based companies doing business in the U.S. and to speak with one voice for the American regulators in international agreements.
Finally, the proponents of federal regulation say that, with the current national focus on systemic risk as a result of the financial crisis, it doesn't matter that the insurance industry escaped widespread instability the last time around; any regulatory structure capable of dealing with future crisis scenarios requires a global view that emphasizes the federal role in insurance regulation.
Thus, the FIO study of the regulatory system will be dealing with issues that are fundamental to the American regulatory environment. Insurers, consumers, and other stakeholders will be eager to have a say in the proceedings.
The FIO and information collection. The FIO's mandate to collect information involves the authority to require any large insurer or insurance company affiliate to submit data at the FIO's request. There is to be some level of exemption for small companies, but the details have not yet been worked out. Further, the FIO has been authorized to recommend to the Financial Stability Oversight Council that it designate an insurer as a systemically significant entity requiring additional supervision by the Federal Reserve.
Reinsurance and nonadmitted insurance
The Dodd-Frank Act will have an immediate effect on reinsurers and nonadmitted insurers, pre-empting state law governing their business. The results are likely to be:
- Greater access to market for nonadmitted insurers
- Single-state regulation and financial reporting for reinsurance companies
Greater access to market for nonadmitted insurers. The new legislation prohibits any state other than the home state of an insured to require licensure of a surplus lines insurer or broker doing business with that insured. It further calls upon the states to standardize their processes of taxing multistate surplus lines risks. Premium taxes will now be paid only in the home state of the insured.
In addition, surplus lines brokers can now place insurance with a nonadmitted insurer without having to first search for an admitted insurer. This change will likely bring about more competition in certain insurance markets, because purchasers will have easier access to nonadmitted insurers.
Large surplus lines companies that sell insurance in many states will likely find this provision beneficial. Small insurers that do business only in one state will not have as much to gain, but it will be to their advantage that their broker does not have to exhaust the admitted market before presenting nonadmitted insurance as an option.
As nonadmitted insurers gain easier access to the market, one thing that purchasers should consider is the possibility of greater risk. Nonadmitted insurers are typically not part of a state's guarantee fund covering insolvencies. Purchasers, therefore, need to be aware that they may not be protected against insolvency of a surplus lines insurer.
The authors of the Dodd-Frank Act appear to be concerned about the prospect of rapid growth and greater risk in the nonadmitted market. The legislation mandates that the Government Accountability Office (GAO) prepare a study on the state of the surplus lines marketplace and the effect of the reform on the size and uses of the nonadmitted market. The GAO must report its findings to Congress within 30 months of the legislation’s enactment.
Regulation of reinsurance. When a ceding insurer wishes to qualify for reinsurance credit on its financial statements, the insurer must meet state rules covering security and other matters. Most states enforce such requirements only upon insurers that are domiciled, or incorporated, within the state; however, some states have been requiring all ceding insurers operating within their state borders to satisfy their qualifying rules, even if the insurer is domiciled in another state and must also satisfy its home state’s rules.
The Dodd-Frank Act stipulates that if the ceding insurer's state of domicile is accredited by the National Association of Insurance Commissioners (NAIC) or has solvency standards similar to those mandated by the NAIC, then other states cannot deny credit for the reinsurance. Thus, a ceding insurer only has to satisfy the rules of one state—a change that will surely have a positive effect on the reinsurance industry. In particular, foreign companies that provide reinsurance within the U.S. will benefit from this new provision.
Modernizing the U.S. insurance industry for a global market
It is a truism that the world is becoming smaller and economic activity more global, and one of the more important implications of the Dodd-Frank Act is that it takes the U.S. insurance industry several steps toward a modernized regulatory system that is more suited to the 21st century. Until now, the U.S. has lagged behind many other countries—those in the European Union (E.U.), for example—in presenting a unified face to the world insurance market. For the U.S. to compete effectively in the global environment, we need to streamline the rules and regulations governing the insurance business and speak as one country when negotiating international agreements.
The reforms in reinsurance and surplus lines insurance, reducing the number of state regulations and the burden of premium taxes, represent a good first step. These changes will align the U.S. more closely with the standards of our global competitors.
Setting up the FIO as a body that has the power to pre-empt the authority of the states in issues involving international agreements enables non-U.S. insurers doing business in the U.S. to effectively deal with just one regulator instead of 51.
It is not only foreign companies that will benefit from the existence of the new federal office. American insurers have a lot at stake in the way international markets continue to develop. For example, in the buildup to Solvency II, there is a need to make sure U.S. capital and accounting standards are in line with those of the E.U., and for that, an authoritative, single voice will be essential. Similarly, when future negotiations take place on any rules and standards affecting the global insurance industry, it will be in our interest for the FIO, or some other federal-level body, to represent the U.S. position.
Conclusion
As a first step toward greater federal regulatory involvement in the insurance industry, the Dodd-Frank Act has established the Federal Insurance Office and set forth new rules liberalizing the states’ regulation of reinsurance and surplus lines insurance. Time will tell whether or not—and to what degree—the federal role in insurance regulation will grow and how and to what extent the insurance marketplace is impacted.
Federal regulation of investment products
Several of the Dodd-Frank Act's provisions affecting the investment world may also have regulatory and financial implications for the insurance industry. Many life insurers purchase derivative contracts or engage in over-the-counter swap transactions to hedge risk. Over-the-counter swaps will now be regulated by the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC), or jointly. Further, most over-the-counter derivatives and swaps will now be required to be traded on a registered exchange or swap execution facility and cleared through clearing organizations.
The Dodd-Frank Act has also created categories of newly regulated entities. Insurers who use swaps to hedge risk may find themselves classified as "Major Swap Participants" and required to register with the CFTC or SEC. Federal registration would subject such insurers to either agency's recordkeeping, disclosure, and reporting requirements, as well as increased margin costs and collateral and/or capital requirements.
Federal regulation of derivatives and swaps may be a benefit for insurers who use these products, through improved transparency, better pricing, and reduction of counterparty risk. However, such benefits may come at the cost of increased scrutiny and expense for insurers themselves. The Dodd-Frank Act leaves agencies wide latitude through studies and rulemaking to determine the scope of the investment-related provisions, making it difficult to predict the full regulatory or economic impact on insurers at this time.
1 Many summaries of the new law are available, both online and in print form. One particularly useful treatment is The Dodd-Frank Wall Street Reform and Consumer Protection Act: Understanding the New Financial Reform Legislation, Mayer Brown LLP, 2010. For the complete text of the legislation, see, inter alia, Text of H.R. 4173: Dodd-Frank Wall Street Reform and Consumer Protection Act online at http://www.govtrack.us/congress/billtext.xpd?bill=h111-4173. For a timeline of the act's implementation, see The Dodd-Frank Wall Street Reform and Consumer Protection Act: An Implementation Timeline, prepared by Sonnenschein, Nath, and Rosenthal LLP, available online at http://www.sonnenschein.com/practice_areas/financial-regulatory-reform/spotlights.aspx. (See Lines 60–67 for insurance industry provisions.)
2 For an excellent summary of what this report will entail, see the Mayer Brown document mentioned in Footnote 1, pp. 56–57.
3 Milliman has been tracking the issue of state vs. federal regulation for some time. See, e.g., Joy Schwartzman and Michael Schmitz, "Shifting the regulatory burden?" Milliman Insight, 21 April 2008, and Ram Kelkar, Joy Schwartzman, and Gary Wells, "Money for nothing?" Milliman Insight, 29 September 2008.