Financial Regulation’s Fatal Flaw

Toward the end of 2007, as rising numbers of Americans walked away from their mortgages, one of the most obscure corners of the financial world burst into public view. Wall Street banks had packaged many subprime mortgage loans into securities sold to institutional investors, such as pension funds and hedge funds. Those securities were hard for even sophisticated money managers to understand. To ease their concerns and obtain the lowest possible interest rates, banks often purchased insurance that would pay investors if an insured security defaulted.

As more and more of the underlying mortgages went sour, the securities themselves began to default, and investors began to fear that some bond insurers lacked the money to pay large claims. The result was chaos in a market that had nothing to do with subprime lending: municipal bonds. Some bonds issued by state and local governments carried insurance from the same companies that insured subprime mortgage securities, and the $2.6 trillion municipals market seized up as investors tried to figure out which insured bonds were at risk. As municipal-bond prices tumbled, the owners of these ultraconservative investments were forced to mark down the value of securities that were performing perfectly well. Some investors had to dump other assets to cover losses on their municipal bonds, pushing stock and bond prices down even further. For several months, states and local governments were all but unable to issue bonds to meet their routine financial needs.

The bond-insurance meltdown of 2007-2008 exemplifies what financial experts call systemic risk--the possibility that problems at one financial institution will spill over to others, creating a cascade of failures with severe economic consequences. When the federal government’s crisis managers belatedly learned of the bond insurers’ woes, though, they learned something else as well: The government had little information about the problem and no tools to deal with it. That is still the case today. Bond insurers, like other insurers, are under state regulation. Washington is not involved.

In a few pages tucked at the end of its 1,500-page financial-oversight bill, the House of Representatives is making a tentative attempt to address that situation. The Senate seems likely to follow a similar course. If this legislation passes Congress later this year, the federal government will collect more data about insurance companies and join a global effort to agree on the standards big insurers must meet. If that effort eventually succeeds, the Treasury could end up with a key role in regulating big insurers. But don’t hold your breath. By tying tighter insurance regulation to an international agreement that is not in prospect, Congress is avoiding the kind of direct federal role needed to curb systemic risk in insurance.

Congress’ Proposed Fixes

Uncle Sam won’t be dealing with complaints about car insurance. The House legislation, and somewhat narrower language put forth in the Senate, addresses far larger issues. For starters, Congress would create a Federal Insurance Office in the Treasury Department. This is a no-brainer: Right now, no one in the federal government is charged with collecting data about insurance companies, much less monitoring their health--a failing that became all too evident when Federal Reserve and Treasury officials belatedly learned of the huge losses at American International Group (AIG) in September 2008. While this office would be a fairly low-level affair, run by a civil servant rather than an appointee confirmed by the Senate, it would at least institutionalize much-needed insurance expertise.

The new office would have two main jobs. The first would be to collect financial information about large insurance companies. The second, almost unnoticed amid the many regulatory issues Congress now wants to address, would involve negotiating an international agreement on regulating the financial strength of large life and property insurers. If such an agreement is ever reached, the federal government could void any state regulations that conflict with it, giving Washington a major voice on a subject on which, until now, it has had no voice at all.

Insurers have long been treated differently from other types of financial companies in the United States. Unlike banking or securities, insurance is strictly a matter of state regulation. For historical reasons, the rates car insurers may charge, the types of assets life-insurance companies may invest in, and the amount of equity capital a fire insurer must have all depend upon state law. Each state has an insurance commissioner whose main function is consumer protection. An insurance commissioner is charged with resolving customer complaints and making sure that insurers based in the state have the financial strength to pay the claims they have insured. Each state also maintains guaranty funds to pay claims in the event an insurer fails, but these funds have little capital and impose severe limits on the amount of coverage guaranteed.

The events that followed the collapse of the subprime mortgage market in 2007 revealed a gaping hole in this regulatory net. While regulators did well at protecting policyholders, they were on the sidelines as problems at some insurance companies reverberated through the financial markets. Protecting the financial system against risks caused by insurance companies is not the state regulators’ job. There has never been an effort to make it their job, because the conventional wisdom held that insurance companies could not cause systemic risk. While the collapse of a big insurer would be painful for policyholders, shareholders, and creditors, the argument went, one company’s failure would not have spillover effects on other parts of the financial system. When systemic risk appeared, state regulators had neither the information nor the tools to deal with it.

Misdiagnosing Systemic Risk

The events that followed the collapse in U.S. housing prices showed that sanguine assessment of systemic risk in the insurance sector to be decidedly wrong. In reality, insurance can give rise to systemic risk in at least three ways. The obscure financial guarantors known as bond insurers, the trading rooms of huge insurance holding companies, and the gigantic reinsurers that backstop the companies that write insurance covering homes or businesses all have the potential to bring other financial firms down.

Bond insurers are specialized companies set up to protect investors against the risk that a bond will go into default. (They are sometimes referred to as monolines, because bond insurance originally was their only line of insurance.) Bond insurers are supposed to manage their affairs so as to obtain top ratings from the big credit-rating agencies (Moody’s, Standard & Poor’s, and Fitch). The issuer of the bond pays a small insurance premium and then sells bonds using the insurer’s credit rating rather than its own. This allows an issuer with a mediocre credit rating to pay several percentage points of interest less than if it sold its bonds without insurance. But if the financial markets believe the bond insurer will be unable to pay claims, the value of any securities it has insured will plummet. Investors who own those bonds could then be forced to recognize losses even if the bond’s issuer is paying interest and principle on schedule. As banks, insurers, and other investors that own the bond scramble to cover the losses, they may have to cut back other financial-market activities, spreading the pain. In the 2007-2008 crisis, the monolines’ state regulators showed themselves unable to address this risk. Their assurance that the monolines were not technically insolvent failed to assuage the concerns of investors who feared that at some point over the long lifetimes of the bonds, the insurers might fail to make good on their guarantees.

A second source of systemic risk arises from trading activities. The derivatives trading that led to the failure of AIG was extreme, but all major insurers have trading desks that deal in securities, commodities, derivatives, and mortgages on a daily basis. The trading activities of a big insurer are similar to those of an investment bank, and create similar risks. If, for example, an insurer were suddenly unable to obtain the short-term money required to support its trading operations, it could end up defaulting on transactions with many other financial institutions. This is not a situation that directly relates to the provision of insurance, and state insurance commissioners are not able to regulate it effectively.

Reinsurance is the third major source of systemic risk. Reinsurers are insurance companies for insurance companies: For a premium, a reinsurer will assume part of the risk of policies sold by property insurers. If a giant reinsurer were to fail, the companies to which it has sold reinsurance could be exposed to unsustainable losses in the event of a natural catastrophe such as a hurricane or a wildfire, and those companies’ woes could then spread more widely through the financial system. The largest reinsurers are very international companies with complex financial structures, and state-level regulators may not have the resources or expertise to oversee them adequately.

Adequately Addressing the Problem

State insurance commissioners are simply not equipped to address these sorts of risks. No state commissioner has the resources or the global perspective required to monitor the interconnections that create risks of a system-wide financial meltdown. This is a field that cries out for federal involvement.

Members of Congress long ago learned the futility of fighting with powerful elected officials in their home states, which is why the federal government has never stepped on state regulators’ turf. The financial-regulation bill approved by the House of Representatives dances around the issue by assigning responsibility to the federal government if and when there is an international agreement on insurance regulation. The language before the Senate Banking Committee is even weaker.

Realistically, no international agreement on financial standards for insurance companies is likely for years to come, if ever. In early January, three multilateral organizations concerned with the financial sector--the Basel Committee on Banking Supervision, the International Organization of Securities Commissions, and the International Association of Insurance Supervisors--put forth the first-ever report calling for consistent regulation across the financial sector. But it is highly unlikely that the 190 jurisdictions involved in supervising insurance, the 110 securities commissions, and the bank regulators and central bankers from 27 countries who make up the Basel Committee will reach a global agreement on this subject anytime soon. Waiting for diplomacy to resolve the problem of systemic risk in insurance means that the issue will not be addressed.

Reforming financial regulation is an extraordinarily complex undertaking. Although insurance plays only a minor role in the current political debate, recent events have shown it to be a significant source of systemic risk. There is no easy way around the fact that controlling this risk will require a direct federal role. State insurance regulators have plenty of important responsibilities, but this is one they are not equipped to handle. By trying so hard to avoid impinging on state authority, Congress will fail to address some of the causes of the global crisis that began in 2007.