Wednesday, April 2, 2008
Optional Federal Charters for Insurers: Desperately Needed Medicine or a Step Toward Destruction?
“Any modern and comprehensive insurance regulatory structure should enhance competition among insurers in national and international markets, increase efficiency, promote more rapid technological change, encourage product innovation, reduce regulatory costs, and, above all, provide the highest quality of consumer protection.” Pg. 129 of the Paulson plan. Paulson’s “Blueprint” reads like a motivational speech, the recommendations contained within seem almost too good to be true. Since I do not know nearly enough about most of the aspects contained in the plan, I will leave the commentary to the expertise of the Red Lion herself, but I thought I would offer a few observations about the proposed nationalized insurance regulations.
Insurance is, as the plan points out, a national industry. Major insurance companies transact business across state and even national borders. Insurance companies currently need to conform their products to the jurisdictions of fifty states plus territories, this is costly and inefficient. Streamlining the governance of the insurance industry seems like a great idea. Plus, with all of the brewing issues surrounding the life settlement industry, it may be an ideal time for the Federal Government to step-in and facilitate consistency. The plan recommends only an optional federal charter, so if a small insurer prefers to be regulated locally, presumably this will be allowed – for now. In spite of 135 years of state-regulation, it may well be time for change. After all, insurance is big business: in 2006, insurance companies held $6 trillion in assets – half of the assets held by the banking industry. This brings me to my next point.
The more insurance looks like a financial tool, the less likely life insurance death benefits will retain their tax-exempt status. The primary purpose of life insurance is to provide security to one who would suffer loss upon the death of another, not to be a security for investors. Courts uniformly recognize the dual-component nature of life insurance, that of both providing a consumable benefit (insurance coverage) and an investment vehicle (the internal cash accumulation of a permanent policy and eventual death benefit). The Internal Revenue Code exempts life insurance proceeds from gross income if paid by reason of the death of the insured, in spite of the investment component of life insurance. Presumably, the IRS doesn’t believe anyone is willing to die for a tax shelter. Insurance companies are able to use this to their advantage in marketing insurance for estate planning purposes – it is a huge selling point. Recognition of the need for national regulation of insurance, to me, suggests that insurance is beginning to resemble other financial tools. This, in turn, makes the argument for special treatment of life insurance less compelling. While one could argue that there is a long way to go before reaching that point, this seems to be a step in that direction – a sobering thought.
Of course, on the flip side, a federal charter may give consumers an advantage they have not had before. The disclosures required of an insurer are minimal when compared to sellers of other financial products. For instance, insurers don’t disclose commissions paid to agents. In contrast, underwriters’ compensation structure must be disclosed when registering a security with the SEC. If commission structures or rates vary across insurance companies, disclosure would facilitate shopping and ultimately drive down cost. Another possible benefit to consumers is that the insurable interest laws, which vary slightly from state to state, could be clarified once and for all – which would have the effect of imposing a heavy burden on any individual seeking to induce an individual to procure insurance for the purpose of reselling it to an investor. This practice, known as STOLI (stranger-originated life insurance – see my earlier post) is poison in the secondary market for life insurance. With federal chartering and enforcement, the incentive for an investor to engage in STOLI may be lessened.
Perhaps the Paulson plan isn’t quite Faust’s deal with Mephistopheles, but we all must go into any situation which seems too good to be true with eyes wide-open.