Kevin P. Hennosy
Insurance Writer / Researcher
7512 Walnut Street
Kansas City, Mo. 64114-1951
(816) 885-1717 khennosy@spreadtherisk.org
T E S T I M O N Y
The National Conference of State Legislatures
At the Chicago Hilton
December 7, 2005
In a landmark 1969 Supreme Court ruling, Justice Thurgood Marshall described the scope of jurisdiction lent to the states by the McCarran-Ferguson Act. Writing for the majority, Marshall defined the “business of insurance” in order to define the states’ responsibilities under the act:
The relationship between insurer and insured, the type of policy which could be issued, its reliability, interpretation and enforcement — these were the core of the ‘business of insurance.”
SEC v. National Securities, Inc. 393 U.S. 453, 460 (1969)
While the term “reliability” seems partially directed at the financial solvency of insurers, the balance of Justice Marshall’s definition addresses concepts related to market regulation. (Reliability can even be read in market regulation terms because an ethically bankrupt company is just as unreliable as a financially insolvent one.)
This market regulatory focus should not come as a surprise to those interested in insurance regulation. The history of insurance regulation tells a story of one effort after another to regulate insurance through private or public frameworks. The Supreme Court decisions in the two cases that have shaped insurance regulation over the past 145 years, Paul v Virginia, 8 Wall 168, 183 and US v South-Eastern Underwriters Association (S.E.U.A.), 22 US 533 (1944), resolved disputes related to market activity. The McCarran-Ferguson act provides a limited and contingent exemption to the business of insurance from two federal mechanisms for market regulation – antitrust law and Federal Trade Commission (FTC) oversight – to the extent that the states regulate.
Market regulation is the central function of insurance regulation.
For this reason I am honored and grateful for the opportunity to participate in the National Conference of State Legislators deliberations on the future of insurance market regulation. As elected state officials, your deliberations will have an important and lasting impact on the lives and security of all Americans. I obviously wish you the best in this endeavor.
Preserving McCarran-Ferguson
I write about insurance history; therefore, I have researched the application of the McCarran-Ferguson Act through the years. With this research, my understanding of the underlying dynamics of the statute grew. At times I may get disgusted with how the act has been implemented; however, I understand the political engineering and wisdom that shaped the act. I still believe that the act serves the public interest in ways that alternative frameworks would not; therefore, I want to see McCarran-Ferguson preserved.
Too often representatives of various interests groups ask state officials for special consideration based on emotional, dogmatic or rhetorical flourish. I still hear testimony laden with dogmatic references to states’ rights, states’ prerogatives and deregulation.
With regard to the states’ rights or prerogatives, my eyes are drawn to the Commerce Clause of the Constitution. Insurance is interstate commerce, and the Constitution rests jurisdiction for interstate commerce with the Congress. The courts have ruled that the Congress may lend this authority to the states as long as it retains oversight responsibilities.
With the passage of McCarran-Ferguson, which was subtitled “an act to regulate insurance,” Congress loaned authority to regulate insurance to the states “to the extent that the states regulate the business of insurance.” I have read the McCarran-Ferguson Act many times and I have yet to find a deregulation provision.
Under McCarran-Ferguson, market regulation is the central function of insurance regulation. For this reason I believe that if the states were ever to lose jurisdiction over insurance, it will not be through an act of Congress.
Rather I believe it is much more likely that if the states lose this jurisdiction it will be the result of federal court decision that finds that the states have not “regulated the relationship” or have acted outside that broad area of jurisdiction.
In short, I worry more about the states being ruled out of compliance with McCarran-Ferguson than I do about the repeal of the act. Numerous societal, economic and political factions could be motivated to challenge state compliance with the act in federal court.
For example, a challenge to McCarran-Ferguson could come from a disgruntled class of individuals who ask for application of antitrust laws in the absence of affirmative regulation by the states. Conversely, a disgruntled sector of the industry or a competing financial services sector, or an ambitious federal agency could challenge the states’ compliance with the act for acting in ways unrelated to the “relationship of insurer and insured.” In either instance a handful of federal judges in a foul mood could find that the states have failed to comply with the act.
As states remove rate and form filing requirements from there regulatory regimen, it may be easier to conceive of a challenge to states compliance by arguing that the states do not “regulate” in the affirmative sense. Such a challenge would ask for the immediate application of federal antitrust law or FTC oversight in a given state or group of states.
The converse situation where a challenge arises from states acting outside of the jurisdiction loaned to the states by McCarran-Ferguson should also hold interest for state officials. The states have already lost a challenge based on this argument before the Supreme Court. In the SEC v. National Securities, Inc. decision that I cited earlier in this testimony, the Court reversed an action taken by Arizona regulators, who approved a merger in the interest of shareholders. The Court reminded the state officials that the charge they receive under McCarran-Ferguson is limited to “the relationship of insurer and insured,” and shareholders fall outside that relationship.
With concerns noted above in mind, I have urged state officials – regulatory and legislative – to be very careful when crafting changes to the regulatory framework. This is not an argument against change; rather it is a plea for deliberation and reason. What Congress and the courts have given the Congress or the courts can take away.
Why is insurance regulated?
Before I discuss my views on how the states should regulate the business of insurance, it is informative to consider why insurance is regulated. Many advocates over the years have asked policymakers with exacerbation why insurance should not be treated like any other business?
The answer to that question is simple: insurance is not like other businesses.
Insurers have battled the demon of unfettered competition since the earliest years of the republic. The history of insurance is littered with the wrecks of companies that succumbed to the siren song of short term competitive forces.
I disagree with commentators who argue that insurers concerns over competition ended with the Civil War. I believe that the “Insurer Insolvency Crisis” of the late 1980s and early 1990s was nothing more than a symptom of unfettered competition in the life insurance sector. Policies and producer compensation systems were designed to attract attention in a hyper competitive market for investment dollars.
Bereft of affirmative regulation in states like California, these competition driven designs led to unsafe investment practices that shook the entire life insurance sector. At one point, the NAIC leadership met with the New York Federal Reserve Bank to suggest plans for the Federal Reserve to provide liquidity to the life insurance sector if the consumer confidence eroded further and insolvencies continued.
If in the early 80s, a state regulator had “regulated the relationship” and stood up to industry leaders like Fred Carr of First Executive and said “No,” I believe the turmoil of a decade later would not have happened. The lack of market regulation undermined the states vaunted solvency efforts.
The first national regulatory framework placed upon insurance came from the industry itself. Alexander Stoddart established a (legal) cartel arrangement called the New York Underwriters Agency in 1864. Stoddart organized a national cartel system for fire insurance before John D. Rockefeller applied the theory of cooperation to the oil industry. On the life insurance side, interlocking corporate boards served a similar purpose.
The use of the word cartel begs a completely different response in the early 21st Century than it did in the 1860s and 1870s. The insurance cartel, among others, was originally greeted as a mechanism for reform. Cartel power forced a certain level of uniformity and discipline upon the insurance sector. Adequate rates and realistic promises resulted from the application of cartel power.
As you may know, it was Stoddart and the National Bureau of Fire Underwriters (now the American Insurance Association) that first tried to secure federal charter legislation from Congress. When the bill bogged down in the Senate, Stoddart tried to put pressure on the Congress by challenging state jurisdiction in the courts. The NYUA’s general counsel, Col. Samuel Paul, held an insurance sales license in Virginia. Col. Paul refused to pay his licensing fee and went to federal court. The fire insurers’ lawyers were surprised when the Supreme Court ruled that insurance was not commerce and therefore could not be interstate commerce.
Contrary to the plaintiffs’ political aims, the decision in Paul v. Virginia closed the door to federal regulation for 70 years. The power of the cartel remained at the state level.
The concentration of such power in private hands ultimately lost public support. Eastern-based insurers effectively refused to do business in large sectors of the Midwest and Southwest. The inability of small town businesses to secure fire insurance coverage put pressure on legislators and Governors to do something.
States attempted to apply antitrust type-laws to break up the cartels even before the Congress passed the Sherman Antitrust Act in 1890. This litigation proved expensive and ineffective even after many states adopted anti-trust acts of their own.
States like Kansas and Missouri acted to establish regulatory frameworks over the cartels. The German American Insurance Company challenged the implementation of the Kansas statute in federal court. The company argued that insurance is not imbued with a public interest, so the sector should not be subject to government regulation.
The Supreme Court found for the state, and provided an argument for why insurance may be regulated. Justice McKenna, a conservative Ohio Republican, wrote:
“The effect of insurance — indeed, it has been said to be its fundamental object — is to distribute the loss over as wide an area as possible. ... Contracts of insurance therefore have greater public consequence than contracts between individuals to do or not to do a particular thing whose effect stops with the individuals. We may say in passing that, when the effect goes beyond that, there are many examples of regulation.”
German Alliance Ins. Co. v Lewis, 233 US 389 (1914)
The states did not receive clear direction that insurance should be regulated until the passage of McCarran-Ferguson in 1945. The business of insurance’s need to “spread the risk” across large populations imbues it with a public interest; therefore, it is proper and necessary to apply the public accountability of regulation to this private sector activity.
How should states apply regulation?
As I noted, the insurance industry instituted the first regulatory framework on the business of insurance. Industry leaders recognized the need to temper the unfettered competition that undermined the insurance mechanisms ability to reserve for future claims.
The anticompetitive imposition of a base level of uniformity by the cartel and interlocking board arrangements did serve the public interest in several ways. The cartel did make products more reliable and uniform. Insurance consumers began to understand the coverage offered in their policies because those policies were not constantly changing. The cartel structure also made companies more reliable. Prior to the construction of the cartel, policyholders were advised never to insure more than 20 percent of property risk with a single company because insolvencies were so common.
The application of federal antitrust law and FTC oversight to the insurance sector by the Courts decision in the S.E.U.A. case made the cartel system legally untenable. Justice Hugo Black acknowledged the long held concerns over insurance and competition:
“Whether competition is a good thing for the insurance business or not is not for us to consider. Having power to enact the Sherman Act, Congress did so; if exceptions are to be written into the Act, they must come from the Congress and not this Court.”
Thanks to intervention of U.S. Sen. George Radcliffe (D-MD) and U.S. Joseph C. O’Mahoney (D-WY) with President Roosevelt, the administration supported Congressional efforts to draft compromise legislation. Senator O’Mahoney in particular, who had investigated the life insurance industry as chairman of the Temporary National Economic Committee (TNEC), sought to design a statutory framework based on three points:
Preserve the states’ claim on jurisdiction over insurance and its taxation
Break the concentrated power of the old anticompetitive system without unleashing unfettered competition on the business of insurance
Apply Congressional oversight in compliance with the Commerce Clause
Even before the S.E.U.A. decision came down the sectors of the insurance industry asked Congress to write such exceptions from antitrust oversight without applying a regulatory framework. U.S. Sen. Homer Ferguson (R-MI.) became the champion of this approach.
Political rivalries divided the insurance industry. Life insurers asked for a temporary exemption from antitrust law, and a permanent exemption from FTC oversight. Fire insurers asked for a temporary exemption from FTC oversight and a permanent exemption from antitrust law. The two major sectors of the industry proved quite willing to stick a legislative sheath in the others back. Everything old is new again.
State regulators lived in denial. If one looks at the NAIC Proceedings from a meeting conducted at the old Edgewater Beach Hotel here in Chicago shortly after the S.E.U.A. decision was announced, it is clear the regulators were at a loss. One speaker after another expressed the belief that the S.E.U.A. decision would never stand – the NAIC’s record of predicting the future is at best a mixed bag.
It was not until the fall of 1944 when the NAIC started working closely with Senator O’Mahoney, the independent agents (then the National Association of Insurance Agents) and organized sectors of the life insurance industry. New York Superintendent of Insurance Robert Dineen led a reform slate of commissioners who took control of the NAIC in December 1944.
The compromise was designed by O’Mahoney, the NAIC and the NAIA. It created a moratorium on the application of federal oversight for 2 years to allow time for state legislatures to act. It expressed the intent of Congress that the states hold and use jurisdiction over insurance and preserved the premium tax. It directed the states to regulate insurance and provided for immediate federal supervision if the states did not regulate insurance. The bill that became Public Law 15 of 1945 provided for a limited and contingent delegation of authority to the states – use it or lose it.
By Christmas week 1944, Sen. Pat McCarran (D-NV) wrote a long telegram to his secretary that reports that O’Mahoney and Ferguson had struck a deal on compromise insurance legislation. McCarran was chair of the Senate Judiciary Committee that held jurisdiction over the issue but he had little to do with the bill.
By the first week of January 1945, Sen. Radcliffe secured the administration’s support for the compromise. Radcliffe also fended off a floor challenge to the bill by Sen. Claude Pepper (D-FL).
When President Roosevelt signed the bill, the White House issued a press release that promised that the business of insurance would be brought under federal supervision at the end of the moratorium. Indeed, through congressional oversight of the state regulatory framework the White House was proved right.
O’Mahoney and Dineen worked together to shape the response to McCarran-Ferguson’s passage. Both men spoke to industry groups to explain that insurance was subject to public regulation and that in the long term this served insurers interests as well. Dineen worked through the NAIC’s processes to create The ALL INDUSTRY bills. O’Mahoney wrote to numerous state legislators, urging among other things the application of state antitrust law to insurance. O’Mahoney’s papers include explanations that the bills were designed to stand in the place of federal antitrust law and FTC oversight. He continued to serve on or chair oversight committees with jurisdiction over insurance until he left office in 1961.
As one would expect, the provisions of McCarran-Ferguson were defined by judicial interpretation One of the early cases that I find interesting addresses the concept of domiciliary supremacy in market conduct regulation.
In the case of Travelers Health Insurance v. Virginia, that domiciliary supremacy does not work when applied to insurance market regulation. The case involves a Nebraska domiciled company that claimed exemption from Virginia. The company argued that its direct mail and local subscriber marketing model meant that its business operations were only subject to Nebraska law. The Court rejected that argument and went further to say that each state must regulate insurer activity in its own jurisdiction.
You may recognize the following cite from amicus briefs produced by the NAIC, state regulators and industry advocates that argued for controls on class action suits. The quote though did not originally deal with court jurisdiction, but with the need for local application of regulation.
And prior decisions of this Court have referred to the unwisdom, unfairness and injustice of permitting policyholders to seek redress only in some distant state where the insurer is incorporated. The Due Process Clause does not forbid a state to protect its citizens from such injustice.
In my opinion, the McCarran-Ferguson Act requires the states to provide that kind of injustice. The act requires that each state regulate insurance, and a historical review of case law and legislative history centers the focus on market regulation.
It is my belief that O’Mahoney regularly fed information to Federal Trade Commission and Justice Department lawyers to initiate litigation that built case law that shaped McCarran-Ferguson implementation. In another case involving the Travelers Health Insurance Company, Justice Potter Stewart wrote the majority opinion. Justice Stewart quoted the Conference Committee Report on McCarran-Ferguson to illustrate his ruling:
"When the moratorium period passes, the Sherman Act, the Clayton Act, and the Federal Trade Commission Act come to life again in the field of interstate commerce, and in the field of interstate regulation. Nothing in the proposed law would authorize a State to try to regulate for other States, or authorize any private group or association to regulate in the field of interstate commerce." 91 Cong. Rec. 1483.
In my historian’s understanding of the ruling, the Court seems to rule out two things. First the decision appears to rule out a market regulation system that relies on a company’s state of domicile to regulate its operations. In addition, the ruling raises questions in my mind as to whether the NAIC interstate compact proposal complies with McCarran-Ferguson. The compact language cedes authority to the compact commission to regulate life insurance, annuities and long-term care insurance. In a series of cases, the Supreme Court has denied compact commission the legal standing of states – regardless of whether the enabling language calls the commission a public entity. If a disgruntled party were to challenge the compact’s validity in court, they could charge that the compact seeks to transfer borrowed authority from the states to a private entity or association in violation of the McCarran-Ferguson Act.
In Federal Trade Commission v. National Casualty Co., 357 U.S. 560, 563, 2 L. Ed.2d 1540 the Supreme Court warned the states that regulation meant more than simply putting an inert phrase or two in state law. The states could not comply with McCarran-Ferguson through a “mere pretense” of regulation. Justice William O. Douglas explained the concept in a decenting opinion when the court denied a writ of certiori in Ohio AFL-CIO, United Auto Workers of Ohio v. Insurance Rating Board, 409 U.S. 917 (1972):
“In Federal Trade Commission v. National Casualty Co., 357 U.S. 560, 563 , 2 L. Ed.2d 1540, after examining the statute and its legislative history, we held that federal regulation as to advertising practices was prohibited in those States which were regulating such practices under their own laws. We indicated, however, that the grant of exclusive regulatory power to the State would be ineffective if the state statutory provisions which purported to regulate were a ‘mere pretense’ of regulation.”
By the early 1970s insurance leaders from the public and private sector argued that competition would be a better regulator than state approval of rates and forms. But this did not make the regulatory aspects of McCarran-Ferguson slip away in to history. A regulatory framework that affirmatively measures and tests fair competition in the market place. NAIC leaders like Bob Dineen and Jon Hanson wrote extensively on this concept. The NAIC also hired the consulting firm McKenzie and Company to write a report on what insurance regulation SHOULD look like.
An agenda for reform
After the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act in 1999, it became clear that sectors of the insurance industry would try once again to seek federal jurisdiction. The NAIC responded to the political threat in a weak manner that featured tossing one political carrot after another to opponents or potential opponents of state regulation. The NAIC response was all carrot and no stick.
The decision was taken to dismantle what became known as “front end regulation.” The NAIC made a quick and poorly considered recommendation to deregulate commercial insurance lines. The NAIC produced a model law that “assumed” competitive markets and placed limitations on the commissioners’ abilities to regulate markets.
There was no saving the NAIC from this frenzy of folly. The commissioners had tasted from the cup of special interest spirits and would not be worth anything for several years.
A few of us understood that after this binge the regulatory system might be nothing more than the “pretense of regulation” that the Court had ruled the states against. The NAIC was putting the state regulatory system at risk.
In May 2001 I filed a comment letter with the NAIC that proposed a system of market regulation. I used the successful system of solvency regulation as my model – consistent with the general tenets of the McKenzie Report and the Dineen / Hanson report.
To my great surprise, influential members of the NAIC seemed to listen. Progress has been slow but measurable. The following outline was drawn from my original proposal for market regulatory reform, and was first presented to the National Conference of Insurance Legislators in:
National Standards
The discipline of market regulation shall clearly identify national benchmarks for effective regulatory oversight and compliance. While local markets and consumers can benefit from the flexibility offered by a state-by-state structure, the regulation of the interstate commerce of insurance requires certain levels of authoritative and administrative resources.
A starting point for the establishment of national standards should be the minimum resource recommendations put forward by the NAIC Market Conduct and Consumer Affairs (D) Committee and the Market Conduct Examiners Handbook.
Uniform Data Protocols
The discipline of market conduct regulation should become more data intensive and follow the example set by solvency surveillance since the 1970s. The NAIC should aid the states in designing and implementing national protocols for market conduct data reporting, collection and storage.
The NAIC Complaint Database should be improved and a uniform protocol for compliant data should be recommended for the states. Other NAIC antifraud databases should be reviewed for data elements that aid in market conduct oversight. NAIC data sources such as the System for Electronic Rate and Form Filing and the Financial Data Repository should undergo the same review.
If the NAIC would adopt an open architecture approach to information technology these data could be integrated with financial and other information sources to form a Competitive Market Data Protocol for use in market analysis.
Analysis and Exams
The discipline of market conduct regulation should provide for an integrated approach to multi-jurisdictional examinations in the case of troubled companies or lines. Market conduct regulation will benefit from the formation the NAIC Market Analysis Working Group (MAWG), ultimately consisting of a subsection of accredited states that will review troubled companies with domiciliary states. When necessary, the MAWG multi-jurisdiction will design and coordinate multi-jurisdiction market conduct examinations.
Consistent Enforcement
The discipline of market conduct regulation must establish norms for effective enforcement. First among these norms must be transparency, and the elimination of consent decrees that only serve to hide problems in return for payment. Very little previous study has been given to market conduct enforcement and study is needed. There may be a need, in the most extreme cases, when ethically bankrupt companies and managements should be removed from the market place through rehabilitations and liquidations - ever bit as much as in the case of financially bankrupt companies.
It is possible to build a national regulatory framework linking the states through consistent expectations and practices – but everyone must keep in how we got here. We cannot simply expect to build efficient framework if we reject the McCarran-Ferguson blueprint and focus on contemporary sloganeering.
Whether or not this reform agenda is ultimately adopted, state officials must keep in mind the tenuous nature of their claim over insurance supervision and taxation that is contingent upon affirmative regulation.
Thank you for the opportunity to discuss these interesting and important issues.
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