Author Archives: SEH

How Should the Federal Government Oversee Insurance?

Oral Statement of Scott E. Harrington

Alan B. Miller Professor

The Wharton School, University of Pennsylvania

On “How Should the Federal Government Oversee Insurance?”

Before the Subcommittee on

Capital Markets, Insurance, and Government Sponsored Enterprises

Committee on Financial Services

United States House of Representatives

May 14, 2009

(These remarks summarize my written testimony.)

Chairman Kanjorski, Ranking member Garrett, and members of the Subcommittee:

I am pleased for this opportunity to testify on an issue of fundamental importance to the economic security of individuals and businesses.  I have three main points, which I elaborate in my written statement.

First, insurance is fundamentally different from banking and should not be regulated the same way.  AIG notwithstanding, insurance markets are characterized by minimal systemic risk and by reasonably strong market discipline for safety and soundness.  Any new regulatory initiatives that affect insurance should be designed not to undermine that discipline.

Systemic risk – the risk that problems at one or a few institutions threaten many more institutions and the overall economy – is much greater in banking than in insurance.  Depositor and creditor runs on banks threaten the payment system.  Banking crises involve immediate and widespread harm to economic activity and employment.

Systemic risk provides some rationale for relatively broad government guarantees of bank obligations.  Because guarantees undermine market discipline, they create a need for tighter regulation and more stringent capital requirements.  This in turn creates significant pressure from many banks to relax capital requirements and improve their accuracy.

Insurance is inherently different, especially property/casualty and health insurance.  There is much less systemic risk and thus need for broad government guarantees to prevent runs that would destabilize the economy.  Guarantees have appropriately been narrower than in banking.  Capital requirements have been much less binding; their accuracy generally has been less important.  This is good economics.  Any new insurance regulatory initiatives should follow this model and continue to recognize the differences between banking and insurance, and that apparently sophisticated capital regulation may produce significant distortions without sufficiently constraining excessive risk taking.

My second main point is that creation of a systemic risk regulator with authority to regulate “systemically significant” insurance organizations would likely have several adverse consequences.  In general, the potential benefits of creating a systemic risk regulator encompassing nonbank institutions strike me as modest and highly uncertain.

Regarding insurance specifically, if an entity were created with authority to regulate any insurer it deemed systemically significant, market discipline could easily be undermined with an attendant increase in moral hazard and excessive risk taking.  An insurer designated as systemically significant would be regarded by many market participants as too big to fail.  Implicit or explicit government backing would lower its funding costs and increase its incentives to take on risk.  I am skeptical that tougher capital requirements or tighter regulation would be adopted for such firms and, if so, be effective in limiting risk taking over time.  Government / taxpayer bailouts could become more rather than less likely.

Even if moral hazard would not increase, it is hardly certain that a systemic risk regulator would effectively limit risk in a dynamic, global environment.  It could well be ineffective in preventing a future crisis, especially once memories of the current crisis fade.

In addition, level competition between insurers designated as systemically significant and those not so designated would not be possible.  The former would likely have a material competitive advantage.  The results would likely include higher market concentration, less competition, and more moral hazard.

Apart from AIG, the insurance sector has withstood the events of the past two years tolerably if not remarkably well.  Some large life insurers have been stressed – hardly surprising given sharp falls in asset values and minimum return guarantees provided on some of their products.  The AIG intervention occurred in response to a liquidity crisis resulting from banking and securities lending activities, often with banks as counterparties.  It was not due to AIG’s core insurance operations, which appear to have been fundamentally sound at the time of intervention.

The full consequences of extending “too big to fail” to AIG, in significant part to protect bank counterparties, are still uncertain.  But the appropriate lessons do not include the need for a systemic risk regulator with authority over insurance.

My third and last point is that legislative proposals for federal intervention in insurance regulation, such as optional federal chartering, should specifically seek to avoid expanding the scope of explicit or implicit government guarantees of insurers’ obligations.  That goal should be central to any debate.

Insurance markets have largely been outside the scope of too big to fail policy until AIG.  Consistent with lower systemic risk, state guarantees of insolvent insurers’ obligations are limited, reducing moral hazard and helping to preserve market discipline.  Customers, especially business buyers and brokers, generally pay close attention to insolvency risk.

Post-insolvency assessment of surviving insurers to fund state guaranty association obligations is appropriate.  Insurers can respond effectively to such assessments without pre-funding.  Potential assessments also provide incentives for financially strong insurers to press for effective regulatory oversight.

If you consider optional federal chartering and regulation of insurers, I hope you will also explore alternatives that could encourage regulatory competition among the states, or that would preempt anti-competitive state regulation.  In any event, I urge you to recognize the central importance of avoiding expanded government guarantees of insurers’ obligations.  This might be achieved under optional federal chartering by requiring federally chartered insurers to participate in state guaranty systems, by or patterning federal guarantees after state guarantees, perhaps with modifications to further enhance market discipline for safety and soundness, thus reducing the need for restrictive regulation.

Thank you.

Conservative communicators: past, present, and future

I am probably one among thousands in my generation who regard the three most important proponents of core conservative principles of our time as Bill Buckley, Ronald Reagan, and, albeit to a lesser degree, Jack Kemp. Among many gifts, these men had the rare ability to articulate the basic principles of freedom, limited government, and strong defense of liberty in ways that resonated widely – Buckley with erudition, Reagan with simple and heartfelt sincerity, and Kemp, at his best, with uplifting passion.

I learned about conservative principles from my parents and especially around my grandmother’s table in the early 1960s. In 1964, I was one of the few 11-year olds in my 6th-grade class (if not the country) who passionately supported Barry Goldwater. I read Conscience of a Conservative, collected campaign buttons, and attended (alone) a rally where he spoke from the back of a train in Champaign, Illinois.

I first read Buckley – dictionary in hand – in my mid teens. As an undergraduate with a rebellious nature toward the end of the Vietnam War I became a pseudo-hippie who espoused liberal causes, including working as a volunteer for McGovern in 1972. Within a few years I had returned to my philosophical roots, having read Atlas Shrugged along the way. I subscribed to the National Review, receiving a weekly dose of Buckley and his gang. While I didn’t realize it at the time, Buckley’s understated religious faith also had influence. It helped me to appreciate that some very smart and articulate people believed in historical Christianity and to start thinking seriously about those issues. Many hours watching Firing Line came later. While I didn’t always agree with Mr. Buckley, he always caused me to think, and to appreciate words. As a small town Midwesterner, I was also charmed by his urbanity and sophistication, somewhat awed by his familiarity with an entirely different world than my own.

I became a fan of Reagan in my early 20s (circa 1975), perhaps in small part due to regional bias. My father was born in Tampico, Illinois, not many years after Reagan was born there. I was born in and later graduated high school from a small steel community on the Rock River, about a dozen miles from Reagan’s boyhood home of Dixon, Illinois. As a teenager I swam in that river and at times would drive through Dixon’s Lowell Park, where Reagan saved many from its treacherous currents. For some reason I don’t recall watching Reagan’s famous speech at the 1964 Republican convention (I couldn’t stay up very late at age 11). Given his age and the visceral hatred and ridicule of him by the left and the national media, I never believed he could be elected President.  His election (President Carter’s main positive contribution to the nation) taught me never to say “never.” Reagan’s communicative ability, charisma, leadership, and fortitude in the face of domestic and foreign perils place him in the same league as FDR. Unlike FDR, he was open, transparent, lacking in guile.  (He also understood economics better.)

Like Buckley and Reagan, Jack Kemp clearly articulated conservative principles.  He inspired and helped instill pride among conservatives. He focused attention on the have not’s by articulating a positive agenda for change based on incentives and empowerment, rather than disincentives and dependence. Had he been chosen as the VP nominee in 1980 and had Reagan-Kemp won, the last 20 years would likely have been much different.  I believe that we would have been in much better shape today.

Who will inspire today’s young conservatives or conservatives in waiting? Charles Krauthammer is a fine and steady source of informed and erudite analysis and opinion, in the intellectual tradition of Buckley.  I’ve become a major fan.  Sarah Palin has charisma and sincerity, and she shows promise as an effective communicator.  Seemingly transparent and guileless, at least by politician standards, she is hated and ridiculed by the left and the mainstream media. It will be interesting to see whether she has the stamina and other qualities necessary to become a national leader. Bobby Jindal is energetic and articulate, with an inspiring personal story and a growing reputation for executive competence. Not unlike Mark Sanford, he has a ways to go on the charisma and oral communication fronts. There are other rising young stars, including some who no doubt are unfamiliar to me. Americans who believe in freedom, limited government, and the strong defense of liberty have every reason to hope for the best.

Farewell, Jack Kemp

For many years Jack Kemp was a leading light for free enterprise and conservative principles.  He will likewise be remembered for his energy, enthusiasm, optimism, and good will.   He truly cared about the urban “underclass” and consistently advocated market-oriented policies as the means to break the cycle of poverty.   As the ideological and political heir to Ronald Reagan, I’m not sure why Mr. Kemp failed to become the Republican Presidential nominee in 1996, but it was the country’s loss.  All conservatives mourn his passing.

(For some details on this man’s influence, see Jeffrey Lord’s The Importance of Jack Kemp in the The American Spectator.)