October 17, 2008
Regulatory Rule #2: Insurance Products Need to be Regulated
Posted by Mike Guttentag

Let’s again consider the scenario in which you are running an agency charged with overseeing financial markets, and you want to prevent a crash similar to the one in October 1987.  What measures should you take? Regulating financial products that mimic insurance is an obvious first step.

Over the centuries, unregulated insurance markets have proven to be prone to failure.  Insurance products require regulation for good reason.  Insurance involves collecting money now in exchange for a promise to provide payments at a later point in time, if certain events occur.  This kind of transaction offers seemingly irresistible temptations to over-collect and under-reserve, and there are often significant limits on the ability of private parties to avoid these risks.  For example, an individual policy holder is unlikely to be able to prevent their insurer from increasing its risk exposure after the insurance policy is purchased.  This is why for over two hundred years insurance products have been regulated.

Recall that the “villain” in the October 1987 crash was a product called portfolio insurance.  Portfolio insurance involved selling equity futures into a declining market to limit losses, and, despite its name, portfolio insurance was a financial strategy, not an insurance product.  Who “sold” the portfolio insurance that ended up bringing down the markets in 1987?  A small company founded by three finance professors. 

But the portfolio insurance trading strategy had the defining attributes of an insurance policy: a promise to shift risks of future declines to another party.  Due to unanticipated market volatility, the cost of getting coverage from portfolio insurance proved to be higher than anyone anticipated.  Would as many institutions have purchased portfolio insurance if they knew how much it would ultimately cost?  Probably not.  Would markets have crashed as dramatically with fewer portfolio insurance holders?  Probably not.  Would a regulatory intervention requiring that the sale of this “insurance” be accompanied with adequate “reserves” have better reflected the actual cost of the insurance? Almost certainly.  Sound familiar?  It should come as no surprise that inadequate insurance regulation is again at the center of a major market downturn.

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Comments (7)

1. Posted by fedgovernor on October 18, 2008 @ 5:57 | Permalink

And who regulates insurance companies?

2. Posted by Elizabeth Brown on October 18, 2008 @ 8:21 | Permalink

The 50 states regulate insurance. There is no regulator of insurance products at the federal level. Whether any particular state will regulate a product as insurance depends on how it defines "insurance." There is no uniform definition of insurance at the state level. As a result, some states regulate some products as insurance while others do not. Sometimes state insurance regulators have been reluctant to regulate a product as insurance out of fear that it will lead to the companies offering to simply move those transactions outside of the state. For example, New York recently announced that it would start regulating some (but not all) credit default swaps as insurnace beginning in January 2009. About one-fifth of credit default swaps have been arranged by firms located in New York. Beginning in Jan., firms offering the credit default swaps fitting under the new regulations would have to obtain licenses as insurers or offer such swaps outside of New York. As a result, many people think that rather than submitting to New York's regulators that they will move outside of New York.

The proposed National Insurance Act (NIA), which Congress has been considering for the past few years, would not necessarily solve this problem. As currently drafted, NIA would allow insurers choose whether they would be licensed by the federal government or the states. It does not allow the federal regulator to impose uniform insurance regulations on the states.

The Insurance Information Act, also being considered by Congress, would allow the federal government to impose uniform insurance regulations on the states but only if such regulations were needed to implement a treaty or international agreement.

3. Posted by Mike Guttentag on October 18, 2008 @ 11:59 | Permalink

I am honored to have Professor Brown join the dialogue. I recommend her recent article, “The Fatal Flaw of Proposals to Federalize Insurance Regulation,” to those interested in learning more about insurance regulation.

The goal of my series of posts is to set out the fundamental principles that should guide regulatory strategy after this current financial crisis. One of the lessons of 1987 is that faulty insurance can lead to an aggregate demand for risky assets that is well in excess of the actual willingness to hold risky assets. No doubt the same is true of the recent financial crisis, and insurance regulation properly expanded to cover its many manifestations should be a central element of regulatory reform, a view that I think Professor Brown would endorse.

4. Posted by Taxrascal on October 20, 2008 @ 18:21 | Permalink

The government is already a de facto insurer against all kinds of risks -- bank failures, pension fund collapses, low income after retirement, unemployment, inability to pay for health care, inability to pay for school, mortgage security prices, etc. So allowing the government to more strongly regulate private insurers isn't fixing the problem -- it's doubling down.

The more pervasive insurance is, the more moral hazard we face. Right now, someone considering an insurance deal must consider the possibility that their insurer may become insolvent. If such insolvency were regulated, insurance buyers would be in the same position as people who bought CDs from dodgy S&L's in the 1980's, or who read the SEC-approved earnings statements of Waste Management and Enron in the 90's. The government is probably not as good at assessing risk as the current risk assessors are, and even if it is, it's less likely to learn from mistakes.

5. Posted by Elizabeth Brown on October 20, 2008 @ 23:01 | Permalink

I am not sure I understand your point. State insurance regulators enforce prudential regulations to try to keep insurance companies from going bankrupt. As part of those efforts, they conduct regular examinations of state insurance companies, just like banks undergo examinations by bank regulators. In addition, all 50 states have guarantee funds that protect policyholders in the event that an insurance company within a state becomes insolvent and is forced into liquidation. These guarantee funds serve policyholders in much the same way as the FDIC acts for bank deposits. The caps for insurance policies under these guaranty funds in most states is $300,000. These funds are paid for by fees assessed on the insurance companies just as FDIC insurance is paid for by fees assessed on banks.

6. Posted by Insurance on October 21, 2008 @ 11:22 | Permalink

Thanks for your article. Insurance is definitely a stressful topic. It's good to have as much knowledge as possible to make an educated decision.

7. Posted by Megan Billard on December 3, 2012 @ 10:13 | Permalink

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