U.S. insurance regulation: GOING FEDERAL

In the assessment of its duty to defend, an insurer is entitled to go beyond the pleadings rule. Recent decisions from the Supreme Court of Canada have shed new light on the thorny question of when an insurer’s duty to defend is triggered.

The National Association of Insurance Commissioners (NAIC) consists of the commissioners of insurance of each of the 50 U.S. states and meets on a regular basis in an attempt to provide some consistency in insurance regulation. Since the U.S. does not have any federal regulation of insurance, each state is entirely responsible for all aspects of the insurance business.

Contrary to the popular view that exists in the U.S., there is actually much less regulation of insurance in Canada. In the U.S., virtually all forms of insurance are subject to both rate and form regulation. The average time that it takes to clear a policy wording and rates through a state department of insurance is approximately 18 months. As a result, making changes in products or introducing new ones becomes a slow and tedious process. Consumers are unable to get products that they may immediately need. In addition, insurance companies are forced to continue to lose money on products that are not properly priced.

In some states, it is not possible to withdraw from certain lines of business without the approval of the department of insurance. It is necessary to clear a new product in every state of the U.S. And, there are significant market conduct penalties that exist if an insurer uses policy wording or rates that are not approved.

INEFFICIENCIES

The U.S. model of regulation of insurance is not efficient and as a result there are a number of exceptions to regulations that exist to allow the market to function. The most important is the “excess and surplus lines” market. This allows companies to avoid form and rate approval for products that have been rejected by the normal markets. There are also a number of other exceptions.

It is interesting that change appears to be occurring in the U.S. with respect to insurance rate. The recent passage of the U.S.A. Patriot Act through Congress which includes a terrorism back-stop will impose some degree of federal regulation of insurance for the first time. Pursuant to it, a state is not allowed to permit insurance companies to exclude terrorism risks.

The McCarran-Ferguson Act exempted the insurance industry from federal regulation in the U.S. There has been significant debate over the last ten years as to whether the McCarran-Ferguson Act should be repealed. It has been argued that the insurance industry would be better served by a national insurance regulator similar to the Securities and Exchange Commission. This is a major constitutional issue in the U.S., and the states are naturally reluctant to give up any power with respect to the regulation of insurance. However, it is likely that the change is inevitable and that more federal regulation will occur.

Banks in the U.S. have also become aggressive in competing with insurance companies on a number of different products such as debt forgiveness. In the U.S., federal banks are totally exempt from both state regulation of insurance as well as form and rate regulation. Banks can basically do what they want without being required to comply with bureaucratic state rules that impair the activities of insurance companies. The result is another level of inconsistency in an already confusing and inefficient regulatory system. The insurance industry in the U.S. is slowly starting to take the view that some form of federal regulation of insurance may be the only way to allow competition with banks and to avoid the numerous problems of state regulation.

CANADIAN MODEL

In comparison to the U.S. system, Canada provides a good model for effective insurance regulation. Our dual system of regulation has slowly evolved from being inefficient with significant overlap to being reasonably well harmonized.

The Canadian Council of Insurance Regulators (CCIR) has done an effective job of standardizing many areas of insurance regulation. The Office of the Super- intendent of Financial Institutions (OSFI) has emerged as the dominant insurance solvency regulator in Canada. It has significant resources and experience that most provincial departments of insurance are unable to match. As a result, there has been a continuing trend to delegate and transfer authority in many areas of insurance regulation to OSFI. The role of provincial departments of insurance is appropriately focused on distribution issues such as market conduct and consumer protection.

The Financial Services Commission of Ontario (FSCO) is a good example of a regulator that is increasingly appropriately delegating its responsibilities to OSFI. For example, the examination of life insurance companies that are provincially incorporated has been fully transferred to OSFI. There are a number of areas of licensing and approvals that are also effectively delegated. If OSFI licenses a federal insurance company, the approval by FSCO for a provincial license has become simplified. FSCO relies on the review done by OSFI and does not attempt to duplicate it. Until recently, FSCO approved transfer and assumption agreements that had already been approved by the Minister of Finance. This requirement was dropped by FSCO several years ago.

It may not be a common view in the industry in Canada that our insurance regulators are doing a good job. However, insurance regulation must be looked at on a relative basis. No industry likes to be regulated but the alternatives to the Canadian model are not particularly attractive. There is evidence that Canadian insurance regulation is being viewed in many other parts of the world as the most efficient model.

Lawrie Savage, who was formerly the superintendent of insurance in Ontario, has been extremely busy as a consultant in a number of countries around the world providing advice as to the effect of regulation of insurance. He has provided advice to a diverse group of countries including Argentina, Mexico, Trinidad, Jamaica and Lebanon. John Palmer, formerly the superintendent of financial institutions, is currently in Singapore working with the Monetary Authority there with respect to insurance regulatory issues. Former Canadian insurance regulators are in demand internationally for their experience with an effective regulatory system.

Although the regulation of insurance in Canada may generally be considered to be done efficiently, there is at least one glaring exception. The regulation of auto insurance must be considered to be a major failure of the Canadian insurance regulatory system. Ontario introduced no-fault auto insurance as well as rate approval in the 1980s as a result of various capacity and pricing issues. There have been a number of changes made to the no-fault systems that have made it difficult for auto insurance to be written on a consistently profitable basis. The Ontario auto insurance industry is currently in a crisis, and it would be hard to argue that either consumers or the insurance industry have benefited.

FUTURE REGULATION

With the collapse of companies such as Enron in the U.S., there has been a significant move towards better corporate governance. There is also a move towards risk-based regulation. The approach of risk-based regulation moves away from detailed rules. It requires an insurance company to understand the risks of its business and to manage then.

Traditional, compliance-based regulation is generally being replaced at the federal level in Canada with a new model based on corporate governance and risk assessment-based regulation.

During 2003, OSFI will be providing a risk rating to each insurance company that it regulates. This risk rating will not be publicly available. The purpose of the risk rating will be to provide information to insurance companies and their boards of directors as to how effectively they are managing risk.

The failure of Confederation Life was probably a critical event in making insurance regulators in Canada realizing that a traditional compliance orientated approach was not an effective way to regulate insurance companies. Confederation Life was able to manipulate the regulatory system by using subsidiaries rather than the parent company to do financings in order to avoid certain rules regarding permitted amounts of debt. These are the same types of techniques that Enron used. Under a corporate governance and risk based supervision system, it is more difficult for this type of behavior to occur since it would clearly be contrary to the intent of the legislation.

Boards of directors will be increasingly scrutinized in the future and must ensure that systems are in place to guarantee compliance with applicable insurance regulatory requirements. OSFI has implemented a number of new requirements over the past few years including “standards of sound business practices” and the requirement to have a “legislative compliance management system”.

Canadian insurance regulators should feel confident that they have generally established an effective system of regulation. OSFI has taken the lead in implementing higher standards of corporate governance as well as risk-based regulatory supervision. However, additional progress is possible – particularly with respect to Ontario auto insurance.