Issue Analysis A Public Policy Paper of the National Association of Mutual Insurance Companies September 2009

The , Systemic , and the Future of Insurance Regulation By Scott E. Harrington, Ph.D.

Executive Summary he bursting of the housing bubble and resulting financial crisis have been followed by the Tworst economic slowdown since the early 1980s if not the Great Depression. This Issue Analysis considers the role of AIG and the insurance sector in the financial crisis, the extent to which insurance involves systemic risk, and the implications for insurance regulation. It provides an overview of the causes of the financial crisis and the events and policies that contributed to the AIG intervention. It considers sources of systemic risk, whether insurance in general poses systemic risk, whether a systemic risk regulator is desirable for insurers or other non- financial institutions, and the implications of the crisis for optional federal char- tering of insurers and for insurance regulation in general.

Causes of the Financial Crisis Factors that contributed to the crisis include:

• Federal government policies encouraged rapid expansion of lending to low-income home buyers with low initial interest rates, low down payments, and lax lending criteria.

• Government-sponsored and private residential mortgage-backed securities, rapid growth in credit default swaps (CDS), and related instruments spread exposure to house price declines and mortgage defaults widely across domestic and global financial institutions in a complex and opaque set of transactions.

• Bank holding companies aggressively expanded mortgage lending and investment, often through off-balance sheet entities that evaded bank capital requirements. Leading invest- ment invested aggressively in mortgage-related instruments.

• Lehman Brothers, AIG, and other organizations became major writers of credit default swaps. When coupled with high leverage, CDS protection sellers became highly vulner- able to mortgage defaults.

• Much residential mortgage lending shifted to an “originate and distribute” model, where originators retained little risk on the mortgages. Subprime mortgage originators were often new entrants with little reputational capital at risk.

Scott E. Harrington is the Alan B. Miller Professor of Health Care Management and Insurance and Risk Management, Wharton School, University of Pennsylvania. The author wishes to thank NAMIC for financial support and Robert Detlefsen of NAMIC for his careful and objective comments. • The kept interest rates of fundamental failures in U.S. and at historically low levels, which fueled foreign banking regulation. housing demand and encouraged lenders to relax mortgage-lending Systemic Risk and the Crisis criteria. • Systemic risk refers to the risk of wide- The Paradox of AIG spread harm to financial institutions and associated spillovers on the real • Apart from AIG, the insurance sector economy that may arise from inter- as a whole was largely on the periphery dependencies among those institu- of the crisis. The AIG crisis was heavily tions and associated risk of contagion. influenced by its CDS portfolio, sold Systemic risk is conceptually distinct by a non-insurance entity, AIG Finan- from the risk of common shocks to the cial Products (AIGFP), which was not economy, such as widespread reduc- subject to insurance regulation. tions in housing prices, which have the potential to harm large numbers of • Rating downgrades and declines in people and firms directly (i.e., without values of securities on which AIGFP contagion). had written credit default swaps The AIG crisis caused it to have to post large amounts • Possible sources of systemic risk was heavily of collateral. AIG also ran into major include: (1) a shock may cause one influenced by its problems with the or more financial institutions to sell CDS portfolio, sold program of its life insurance subsid- large amounts of assets at temporarily by a non-insurance iaries when borrowers requested the depressed prices, further depressing return of large amounts of collateral. prices and market values of insti- entity, AIG AIG’s overall investment portfolio tutions that hold similar assets; (2) Financial Products was significantly exposed to loss from shocks to some firms may make them (AIGFP), which reductions in values of mortgage- unable to honor their commitments, was not subject related securities. causing some of their counterparties to insurance to likewise default, with repercussions • Much of the federal government’s that cascade through financial markets; regulation. financial assistance to AIG was (3) revelation of financial problems at provided for the benefit of AIG’s CDS some institutions may create uncer- and securities lending counterpar- tainty about the effects on counter- ties, primarily domestic and foreign parties and whether other institutions banking and investment banking orga- face similar problems, so that parties nizations. It is not clear that any of become reluctant to trade until further AIG’s insurance subsidiaries would information becomes available; and (4) have become insolvent if the Federal possibly irrational contagion, where Reserve had not intervened. investors and/or customers with- draw funds without regard to whether • AIG was subject to consolidated regu- specific institutions are at risk. lation and oversight by the federal Office of Thrift Supervision and was • Prior research, which largely predates recognized as such for meeting the the growth of credit default swaps 2005 E.U. regulatory criterion for and complex , provides group supervision of financial service almost no evidence of irrational conta- entities. If the financial crisis and gion and little evidence of contagion AIG intervention are to be blamed related to counterparty risk, asset on ineffective regulation, the blame prices, or uncertainty/opacity. should reflect the substantial evidence

2 • The AIG crisis and general finan- appropriately been narrower in scope cial crisis were precipitated by the than in banking, and market discipline bursting of the housing price bubble is generally strong. Capital requirements and attendant increases in actual and have been much less binding – insurers expected mortgage defaults, which commonly have held much more capital greatly reduced the values of mort- than required by regulation. gage-related securities as new infor- mation was reflected in prices. While Proposed Regulation of there apparently were some elements “Systemically Significant” Insurers of contagion, the principal problem was the decline in values. • A June 2009 U.S. Treasury white paper proposes regulation by the Federal • Whether AIG’s CDS portfolio and Reserve of insurance and other non- securities lending presented signifi- bank institutions it would designate as cant risk of contagion has and will systemically significant. A bill intro- be debated. Little is known about the duced by Representatives Melissa Bean extent to which an AIG bankruptcy (D-Ill.) and Edward Royce (R-Calif.) would have had significant adverse would create an optional federal char- effects beyond its counterparties, or tering system for insurers under which Systemic risk is even the extent to which its counter- the President would designate an agency low in insurance parties had hedged their bets with as systemic risk regulator for systemi- markets compared AIG or otherwise reduced their risk. cally significant state and federally char- tered insurers. The agency could force with banking, Systemic Risk in Insurance an insurer to be federally chartered. especially for property/casualty • Systemic risk is low in insurance • Strong arguments against creating a insurance, in part markets compared with banking, systemic risk regulator that could desig- because insurers especially for property/casualty insur- nate insurers and other non-bank finan- ance, in part because insurers hold cial institutions as being subject to hold greater greater amounts of capital in rela- comprehensive regulation and oversight amounts of capital tion to their liabilities, reducing their by the Federal Reserve or other agency in relation to their vulnerability to shocks. Moreover, include: liabilities. shocks to insurers do not threaten the economy’s payment system, as might – Any institution designated “systemi- be true for shocks to commercial cally significant” would be regarded banks. as , reducing market discipline and aggravating moral • Banking crises have the potential to . produce rapid and widespread harm to economic activity and employ- – Implicit or explicit government guar- ment, which provides some ratio- antees of the obligations of any insti- nale for relatively broad government tution designated systemically signifi- guarantees of bank deposits and strict cant would provide it with a material capital requirements. Because insur- competitive advantage and lower its ance, especially property/casualty, cost of capital compared with compa- poses much less systemic risk, there is nies not so designated. less need for broad government guar- antees to prevent potentially wide- – Political pressure, the history of bank spread runs that would destabilize the capital regulation, and incentives for economy. Insurance guarantees have regulatory arbitrage make it doubtful

3 that stronger capital requirements authority before and during the crisis? would offset the increased moral The answer is not clear and has not hazard and unequal competi- been provided. tive advantage versus institutions not designated as systemically The Crisis and significant. Optional Federal Chartering – A systemic risk regulator could have • The financial crisis and AIG an incentive to prop up an institu- have not significantly strengthened the tion designated systemically signifi- case for optional federal chartering of cant even if the institution’s finan- insurers. An assertion that mandatory cial problems had little potential for federal chartering should be adopted systemic consequences. for insurers designated as systemi- cally significant is subject to the argu- • The argument that AIG’s problems ments against a systemic risk regulator and federal intervention make a prima outlined above. AIG’s problems cannot facie case for a systemic risk regu- be primarily attributed to any insur- lator for large and interconnected ance regulatory failure. Given what we The argument that non-bank financial institutions does currently know, AIG would likely have AIG’s problems not adequately consider the poten- been able to largely if not completely and federal tial benefits and costs. It does not meet its obligations to policyholders intervention make consider the failures of federal regu- without federal intervention, with state a prima facie case lation of large banking organizations insurance guaranty funds serving as a potentially important backup. for a systemic risk that contributed to the financial crisis. It largely ignores the regulated insur- regulator of large, ance sector’s comparatively modest • In view of what happened at Citibank, interconnected role in the crisis. It provides no guid- Bank of America, and other bank and non-bank financial ance for limiting the scope of discre- investment bank holding companies, a institutions ignores tionary federal authority to intervene strong case for federal insurance regu- the regulated in the financial sector in particular and lation in response to the crisis would the economy in general. have to explain how federal regula- insurance sector’s tion of AIG before the crisis would modest role in the • It is hardly certain that a systemic risk specifically have prevented or miti- crisis. regulator would be effective at limiting gated its problems. There can be no risk in a dynamic, global environment. presumption that federal regulation The financial crisis underscores (1) the of AIG’s insurance operations would imperfect nature of federal regulation have prevented or mitigated risk taking of banks and related institutions, (2) at AIG, or that optional federal char- the necessity of renewed vigilance in tering with or without mandatory banking oversight and capital require- federal chartering for large insurance ments, and (3) the desirability of organizations would mitigate any role encouraging additional market disci- of insurance in some future financial pline in banking. crisis. It’s just as likely or more likely that federal regulation of large insurers • The federal government was able to would have further increased risk. intervene in AIG and limit any poten- tial contagion without the authority Implications for to regulate AIG ex ante. The question Insurance Regulation arises: What would the Federal Reserve or some other federal agency have 1. A primary objective of legislative and done differently if it had systemic risk regulatory responses to the financial

4 crisis should be to encourage market to recognize the distinctive nature discipline as a means to promote of insurance markets. Given limited safety and soundness in banking, systemic risk and potential for conta- insurance, and other financial insti- gion, government guarantees of tutions. An overriding goal of any insurers’ obligations are appropriately changes in regulation in response to narrower in scope than in banking, the AIG anomaly should be to avoid and market discipline is reasonably extending explicit or implicit too-big- strong. Strong market discipline favors to-fail policies. capital requirements that generally are easily met by the bulk of insurance 2. The financial crisis and AIG inter- companies, reducing potential undesir- vention do not justify creation of a able distortions of sound companies’ systemic risk regulator with authority operating decisions and incentives for over insurers and non-bank insti- evading the requirements. tutions designated as “systemically significant.” The creation of a systemic 6. Creating some form of federal insur- risk regulator would very likely under- ance information office to provide mine market discipline and protect information, serve as a liaison on insur- even more institutions, investors, and ance issues with Congress, and repre- consumers from the downside of risky sent the United States in international behavior. insurance regulatory forums would be The financial sensible, with suitable safeguards of crisis and AIG 3. The financial crisis and AIG interven- state authority. The creation of a federal intervention do tion do not fundamentally strengthen council to monitor domestic and inter- not fundamentally arguments for either optional or national financial institutions and the strengthen mandatory federal regulation of economy for developments that could insurance. Systemic risk aside, any pose systemic risk and potentially lead arguments for debate over optional federal char- to a future crisis could also be useful. either optional or tering of insurers should likewise mandatory federal recognize the central importance of regulation of avoiding expanded government guar- Introduction insurance. antees of insurers’ obligations. he bursting of the housing bubble and resulting financial crisis have been 4. Recent events do not justify broad T followed by the worst economic slowdown authority for the FDIC or some other since the early 1980s if not the Great Depres- federal agency to selectively seize sion. As subprime mortgage defaults rose in and resolve financial troubled insur- 2007, the Federal Deposit Insurance Corpo- ance organizations or other non- ration (FDIC) closed down a number of banking organizations. The ques- major subprime lenders. The Federal Reserve tion of whether regulatory authority rescued investment bank Bear Stearns with a for resolving financially distressed, $30 billion guarantee to facilitate its acquisi- non-bank organizations should be tion by J.P. Morgan in March 2008. September expanded in any way deserves more 15-16, 2008, saw investment bank Lehman study before being given serious Brothers file for bankruptcy, the distressed sale consideration. of investment bank Merrill Lynch to Bank of America, and the announcement of an $85 5. The financial crisis does not suggest billion bailout of American International any need for fundamental changes Group (AIG). in U.S. insurance company capital requirements, which should continue

5 Congress enacted the $700 billion Troubled Causes of the Financial Crisis Asset Relief Program (TARP) in October, which was followed by massive infusions While the varied and complex causes of the of capital into numerous banks, including 2007-2009 financial crisis will be studied and the nine largest, along with large guarantees debated for decades, the popular media have of bank debt. Other federal interventions often focused on alleged “Wall Street greed,” included hundreds of billions of dollars of and, to a lesser extent, the alleged evils of guarantees to support money market mutual financial “deregulation.” The early consensus funds, commercial paper, and numerous among researchers and policy analysts is that asset-backed securities. incentive compensation arrangements in the financial sector contributed to aggressive The underlying causes of the financial crisis risk taking in residential mortgages and real and how it was transmitted across firms, estate, and it is possible that certain relax- sectors, and borders will be studied and ations in regulation also played a role. It is debated for years. Whatever the causes, the clear that many parties made aggressive bets crisis has led to numerous proposals for that housing prices would continue to rise or changes in , including at least not fall, contributing to the housing the proposed creation of a systemic risk price bubble and leading to widespread regulator and expanded federal government financial distress when the bubble burst. It authority to resolve financially distressed is also clear that a number of government non-bank institutions. The proposed policy and regulatory failures contributed to Many parties made the crisis. aggressive bets changes have been motivated in significant part by the financial distress, bailout, and that housing prices quasi-nationalization of AIG, the world’s While their relative importance is debatable, would continue to largest, publicly traded insurance organi- the following factors all contributed to the 1 rise. It’s also clear zation. In addition to providing impetus crisis: for the creation of a systemic risk regulator that government • Federal government policies encour- policy and and expanded federal authority to resolve financially distressed non-bank entities, aged the Government Sponsored regulatory failure proponents of optional federal chartering Enterprises (GSEs), Fannie Mae contributed to the of insurers argue that the AIG interven- and Freddie Mac, to expand rapidly crisis. tion makes some form of federal chartering through the early 2000s, in significant essential. part to support lending to low-income home buyers. The Community Rein- This Issue Analysis considers the role of AIG vestment Act and pressure from the and the insurance sector in the financial Department of Housing and Urban crisis, the extent to which insurance involves Development likewise encouraged systemic risk, and the implications for insur- commercial banks to expand mort- ance regulation. I begin with a brief over- gage lending in low-income, minority view of the causes of the financial crisis. I neighborhoods. then explore the events and policies that contributed to the AIG intervention. This • Subprime and Alt-A mortgage lending synopsis is followed by an elaboration of the with low initial interest rates and little meaning of systemic risk and whether insur- required down payment accelerated ance in general poses systemic risk. I discuss during the middle part of the decade whether a systemic risk regulator is desir- in conjunction with rapid growth in able for insurers or other non-bank financial private, residential mortgage-backed institutions. The last two sections address securities and explosive growth in the implications of the crisis for optional credit default swaps (CDS) and related federal chartering of insurers and for insur- instruments, which spread exposure ance regulation in general. to house price declines and mortgage

6 defaults widely across domestic and dential mortgages caused the risk of global financial institutions. housing price declines and mortgage defaults to be spread widely among • With the federal deposit insurance financial institutions in a complex umbrella protecting depositors in and opaque set of transactions. This their bank subsidiaries, bank holding complexity and opacity created substan- companies aggressively expanded tial uncertainty about the financial mortgage lending and investment exposure of different institutions. in competition with investment banks and other financial institu- • Residential mortgage lending in signifi- tions, commonly through off-balance cant measure changed to an “originate sheet entities that evaded bank capital and distribute” model, where mort- requirements. gage originators retained little risk on the mortgages that were securitized and • The leading investment banks, which distributed broadly among financial had all converted from partnerships institutions. Subprime mortgage origi- to corporations with limited liability, nators were often new entrants that had likewise invested aggressively in little reputational capital at risk, and competition with investment banking they did not have to hold the mortgages. subsidiaries of bank holding compa- nies.2 In 2004 they voluntarily agreed • Because many subprime borrowers When coupled to be subject to consolidated supervi- acquired properties with little or no with high sion by the Securities and Exchange money down, they faced relatively leverage, Lehman Commission (SEC) in order to meet little loss if housing prices fell and they Brothers, AIG, the requirements of a European defaulted on their mortgages. Many and other sellers people took low-cost mortgages on Union (E.U.) regulatory directive of credit default requiring consolidated supervision investment property to speculate on of their E.U. subsidiaries. The agree- housing-price increases. Others took swaps became ment relaxed capital requirements low-cost second mortgages to fund highly vulnerable for the investment banks’ broker- consumption. to increases in dealer subsidiaries. Whether and how mortgage defaults. much this change motivated them • The Federal Reserve played a key role to increase their leverage has been in promoting aggressive borrowing debated.3 and lending. It kept interest rates at historically low levels until it was too • Lehman Brothers, AIG, and others late to prevent a severe correction in became major writers of CDS instru- housing prices and construction. The ments, which, as discussed further low-interest rate policy fueled housing below, offered domestic and foreign demand and encouraged lenders to banks and financial institutions rela- relax mortgage-lending criteria. tively low-cost protection against reductions in values of mortgage- What role did the insurance sector play? related securities. When coupled with The collapse and bailout of AIG has domi- high leverage, CDS protection sellers nated discussion of this issue and created an became highly vulnerable to increases impression that insurance was somehow a in mortgage defaults. central part of the crisis. However, as I elabo- rate below, the insurance sector as a whole • The of subprime mort- was largely and perhaps remarkably on the gages and explosion of CDS and more periphery of the crisis. Apart from AIG, where complex derivatives linked to resi- much of its problems arose from non-insur-

7 fund their retirement savings and who were Figure 1 partially protected from the sharp decline in AIG Revenue Distribution Before the Downturn stock prices in the second half of 2008.5 12-months ending December 31, 2006 A number of insurance companies have Domestic Life Insurance and sought and received permission in some Retirement Services states to modify financial reporting to 6 14.8% Foreign Life improve their reported capital. Six insurers Insurance and applied for and were authorized to receive Retirement Services TARP funds. Four of them (Allstate, 29.1% Ameriprise Financial, Principal Financial, Foreign General and Prudential Financial) subsequently Insurance 10.5% declined to receive the funds. Hartford Financial received $3.4 billion; Lincoln Financial received $950 million. Another major life insurer, Met Life, declined to seek TARP funding. Genworth Financial applied Financial Services (including AIGFP) for but was denied funding. Apart from AIG, 8.6% the insurance sector has represented a negli- Domestic gible amount of TARP funding and other General Insurance Asset federal assistance (see below). 32.5% Management 4.5% Leading “monoline” mortgage and bond insurers experienced significant losses and Source: AIG 2006 SEC Form 10-K highly publicized downgrades by financial rating agencies. None of these firms has thus ance activity, property/casualty insurers far become impaired or received a direct and most life-health insurers have thus far federal bailout. Insurance law and regula- escaped severe adverse consequences from tion mandate a monoline structure for such the subprime meltdown and attendant insurers and require substantial contingency financial crisis. Even AIG’s property/casu- reserves, including a requirement that half alty subsidiaries appeared reasonably well of all premiums written each year be held capitalized at the end of the third quarter of as a contingency reserve for 10 years. This 2008, with moderate leverage, relatively safe regulatory framework helped prevent their assets, and a relatively high risk-based capital problems from spilling over to other lines of ratio.4 insurance, in contrast to what occurred in commercial and investment banking.7 A number of large life insurers have expe- rienced a certain degree of financial stress The Paradox of AIG and financial rating downgrades. This is not surprising given their extensive long- The collapse, bailout, and quasi-nation- term investment in mortgages, other fixed alization of AIG were arguably the most income securities, and common equities to shocking development in the financial crisis. fund asset accumulation products, including The initial $85 billion assistance package has many contracts with minimum return guar- subsequently been modified on several occa- antees. These insurers’ financial stresses sions, with total federal commitments to resulting from contracts with minimum provide assistance growing to $182.5 billion return guarantees have coincided with or more and assistance to date totaling substantial benefits to the individuals and almost $122 billion. As elaborated below, businesses that bought those contracts to most of the assistance has been paid to bank

8 and investment bank counterparties in is obligated to make either a cash payment credit default swaps and security lending to the buyer or pay the notional amount of transactions. the underlying securities in exchange for the underlying securities. AIG is a complex organization consisting of approximately 70 U.S. insurance companies Credit default swaps are not legally considered and 175 non-U.S. companies and insurers to be insurance,9 and U.S. insurance regu- doing business in 130 countries. At year-end lation prohibits insurance companies from 2006, before its financial condition began to writing credit default swaps. They have some erode, domestic property/casualty (general) economic characteristics similar to insur- insurance represented 32.5 percent of its ance, but the protection buyer does not need revenues; domestic life insurance and retire- an insurable interest in the underlying securi- ment services represented 14.8 percent (see ties or exposure. They transfer risk from the Figure 1). Foreign insurance operations of protection buyer to the protection seller, and all types represented another 39.6 percent of they involve some degree of risk spreading by its total revenues. “Financial services,” which the protection buyer. By writing credit default included consumer , aircraft leasing, swaps on many underlying securities, some of and AIG Financial Products (AIGFP), a the risk of selling protection can be diversified subsidiary of the AIG holding company away. However, credit default swaps inher- Credit default operating out of London, represented 8.6 ently pose significant risk of catastrophic loss swaps are not percent of revenues. in the event of deterioration in credit quality insurance. While represented 4.5 percent. throughout multiple sectors of the economy. they have some characteristics The crisis at AIG was heavily influenced by AIGFP and divisions of many investment AIGFP’s CDS portfolio. Rating downgrades banks and bank holding companies were similar to and declines in values of “super senior primary players in the CDS market as it insurance, the multi-sector Collateralized Debt Obliga- expanded rapidly during the past decade. buyers of CDS tion (CDO)” securities on which AIGFP had AIGFP had $533 billion (net notional protection need written credit default swaps forced AIGFP amount) of credit default swaps outstanding not have an to post large amounts of collateral. By the at year-end 2007. AIG categorized 71 percent end of August 2008, it had posted about $20 of this amount as representing “Regulatory insurable interest billion of additional collateral for its CDS Capital” contracts. These contracts gener- in the underlying portfolio. AIG also ran into major prob- ally offered protection against credit-related security. lems with the securities lending program of losses on corporate loans and prime residen- its life insurance subsidiaries, which had $69 tial mortgages. They were largely sold to E.U. billion in loans outstanding at the end of banks, which by buying protection from AIG August. Borrowers began requesting returns were able to reduce or even eliminate capital of large amounts of collateral in September. requirements for holding the underlying secu- The liquidity problems created by collateral rities under the first Basel Agreement.10 The calls for both programs “were significantly buyers of the AIG swaps (and those sold by exacerbated by the downgrades of AIG’s investment banks) were engaging in regula- long-term debt ratings by S&P, Moody’s, tory arbitrage to reduce their required capital and Fitch on September 15, 2008.” 8 during transition to the new requirements under Basel II, which would allow the largest AIG’s CDS Portfolio banks to reduce required capital based on internal capital models. In a basic , the protection seller agrees to protect the protection buyer AIG classified the remainder of AIGFP’s CDS against events associated with portfolio as “Arbitrage.” At year-end 2007, the specified underlying securities. If a speci- arbitrage CDS portfolio was divided between fied credit event occurs, the protection seller

9 credit default swaps on “multi-sector CDOs” cheap given the risk of loss at the time they ($78 billion notional value) and on corpo- were written. The contracts clearly were not rate loans/collateralized loan obligations backed by anything close to the amount ($70 billion). The bulk of the multi-sector of capital that would have been needed to CDO swaps were written on “super senior” respond to reductions in the value of the tranches of the underlying securities, which underlying securities and collateral calls by included residential mortgage-backed securi- counterparties. If AIG’s credit protection was ties (RMBS), commercial mortgage-backed underpriced, its counterparties either were securities (CMBS), and collateralized debt unaware or didn’t care, perhaps because they obligations. Of the $78 billion multi-sector believed that AIG either could not or would CDO swap portfolio, $61 billion included not be allowed to default. some exposure to subprime mortgages. AIG’s Securities Lending Program The super senior tranches of the securi- Securities lending has been common among ties underlying AIG’s credit default swaps financial institutions for many years. It would not be impaired unless the underlying involves one institution, such as a life insurer, tranches, including a triple-A rated tranche, lending securities to another, often a broker- were exhausted. AIG’s internal credit-risk dealer (e.g., for executing short sales or diver- models predicted that the risk was negligible. sification). The borrower posts collateral AIG ceased writing new multi-sector CDO Credit default in the form of cash or high-quality securi- products in 2005 as the housing market swaps sold by ties, typically in the amount of 102 percent slowed and subprime loan experience began AIGFP and other to 105 percent of the value of the borrowed to deteriorate. As housing prices began to non-insurance securities. The lender reinvests the collateral fall and defaults of subprime mortgages entities were not and earns any spread between the returns increased further in 2007 and 2008, AIG backed by the on the invested collateral and the returns had to post increasing amounts of collateral large amounts of on the underlying securities. The spread is with its multi-sector CDO swap portfolio capital that would sometimes shared between the lender and counterparties, which ultimately precipi- be held to back the borrower. tated intervention by the Federal Reserve in sale of insurance September 2008. with catastrophe The significant declines in the values of exposure. many assets during 2007-2008 reduced the Credit default swaps sold by AIGFP and values of reinvested collateral in many secu- other non-insurance entities were not backed rities lending programs. Borrowers termi- by the large amounts of capital that would be nated the transactions at unprecedented held to back the sale of insurance with catas- levels in order to improve their liquidity and trophe exposure. Some protection sellers reduce exposure to lenders’ credit risk. AIG, apparently hedged a significant amount of a major player in securities lending through their risk by purchasing credit default swaps its life insurance subsidiaries, was caught up or other contracts. On the other hand, CDS in this process. Although AIG’s problems writers commonly increased their bets on with its CDS portfolio often are regarded housing prices by investing directly in mort- as the sine qua non of its liquidity crisis and gage-backed securities and other securities federal intervention, it also was threatened by vulnerable to reductions in housing prices. billions of dollars of collateral calls under its

securities lending program associated with Given the large losses stemming from its domestic life insurance subsidiaries.11 AIGFP’s super senior multi-sector CDO

swap portfolio, it’s obvious that the swaps AIG had $82 billion in liabilities for securi- were underpriced in an ex post sense. Many ties lending at year-end 2007, down from observers believe that the contracts were close to $100 billion at its peak earlier in the underpriced ex ante; i.e., they were too year. As noted above, it had $69 billion in

10 loans outstanding at the end of August 2008. anty from the holding company to offset Its U.S. securities lending program repre- losses of the life subsidiaries.14 sented the bulk of the total, involving 12 life insurer subsidiaries, three regulated by the AIG’s securities lending program significantly New York Insurance Department (NYID). increased its liabilities, leverage, and vulner- ability to the housing/subprime mortgage AIG primarily loaned government and high- crisis. The program contributed to solvency quality corporate bonds, receiving cash concerns for the holding company, as opposed collateral. According to the NYID, almost all to simply liquidity issues.15 While noting that of the U.S. collateral was invested in triple- concern over AIG’s securities lending program A securities. About 60 percent of the U.S. was justified, Superintendent Dinallo also collateral pool was invested in mortgage- testified that problems with AIGFP “caused backed securities.12 As AIG noted in its 2008 the equivalent of a run on AIG” and that SEC Form 10-K: detailed analysis by the department “indicates that the AIG life insurance companies would The cash was invested by AIG in not have been insolvent” without the federal fixed income securities, primarily rescue. That analysis is not publicly available.16 residential mortgage-backed secu- rities (RMBS) to earn a spread. Following federal intervention, AIG had During September 2008, borrowers contributed $22.7 billion to its domestic life began in increasing numbers to insurance subsidiaries through February 27, The fact that request a return of their cash collat- 2009, to offset reductions in the value of fixed eral. Because of the illiquidity in the maturity investments, “$18 billion of which AIG’s investment market for RMBS, AIG was unable was contributed using borrowings under the portfolio was to sell the RMBS at acceptable prices Fed Facility.” It contributed $4.4 billion ($4 significantly and was forced to find alterna- billion from the Fed Facility) to its foreign life exposed to loss tive sources of cash to meet these subsidiaries through December 31, 2008, in from reductions requests.13 response to liquidity needs and the decline in equity markets.17 in the value of If available, AIG could have sold other, more mortgage-related liquid assets to meet security lending collat- Insurers have curtailed securities lending in securities was a eral demands — there is no required linkage response to the crisis. Insurance regulators significant source between how collateral is invested and how expanded reporting requirements for secu- of its trouble. collateral calls are met. It is therefore clear rities lending, especially regarding collateral that, in part due to collateral demands asso- requirements, beginning with statutory finan- ciated with its CDS portfolio, AIG did not cial reports filed for 2008. have available other liquid assets, such as cash or marketable securities. AIG’s Overall Investment Portfolio

Regardless of how it was financed, the fact Insurers have long been required to report that AIG’s overall investment portfolio was information about securities lending in their significantly exposed to loss from reductions statutory (regulatory) financial reports. On in the value of mortgage-related securities March 5, 2009, then-NYID Superintendent represents a third and related source of its Eric Dinallo testified before the U.S. Senate trouble. AIG’s consolidated investment port- Banking Committee that the department folio predominantly consisted of fixed income was engaged in discussions with AIG about securities, almost all of which were classi- its securities lending program as early as July fied as “available for sale” under GAAP finan- 2006, “began working with the company to cial reporting. Table 1 shows the mix of AIG’s start winding down the program” in 2007, fixed maturity available for sale portfolio at and ultimately negotiated a $5 billion guar- the end of 2007 and 2008. The fair value of its

11 of securities lending liabilities). The long- Table 1 term debt was an obligation of the holding AIG Fixed Maturity Portfolio company and not the insurance subsidiaries. (available for sale) While subordinated to policyholder claims, AIG’s long-term debt significantly increased 2008 2007 the parent’s vulnerability to reductions in the Category Value Value Percent Percent value of its invested assets. $ millions $ millions All Bonds AIG reported a net loss of $99 billion for U.S. government $4,705 1 $8,252 2 2008, including net realized capital losses of State and municipal $62,257 17 $46,854 9 $55 billion, of which $51 billion reflected Non-U.S. government $67,537 18 $70,200 14 “other than temporary” impairment charges Corporate Debt $185,619 51 $241,519 48 to the estimated fair value of fixed maturity Mortgage backed, asset backed and collateralized $47,326 13 $134,500 27 investments, including $38 billion for its life Total $366,444 100 $501,325 100 insurance and retirement services segment. Mortgaged backed, asset backed and collateralized Severity-related impairment charges of $29 RMBS (except AIGFP) $29,752 63 $84,780 63 billion were “primarily related to mortgage- CMBS (except AIGFP) $11,226 24 $22,999 17 backed, asset-backed and collateralized CDO/ABS (except AIGFP) $6,131 13 $10,447 8 securities and securities of financial institu- AIGFP $217 0 $16,274 12 tions.”18 Unrealized market valuation losses Total $47,326 100 $134,500 100 on the AIGFP super senior CDS portfolio RMBS (except AIGFP) totaled another $29 billion. U.S. agencies $13,308 45 $14,825 17 Prime non-agency $10,801 36 $21,074 25 The Federal Bailout Alt-A $4,209 14 $23,746 28 The details of ongoing federal assistance to Other housing related $379 1 $3,946 5 AIG, which began on September 16, 2008, are Subprime $1,055 4 $21,189 25 complex. The key arrangements have been Total $29,752 100 $84,780 100 modified several times. The details of the transactions are spread among many sources Source: AIG 2008 SEC Form 10-K. and are sometimes opaque. Table 2 presents a summary of the broad details that I prepared mortgaged-backed, asset-backed collateral- from a variety of sources. While I believe that ized investments was $135 billion at year-end the details shown in Table 2 are reasonably 2007, representing 27 percent of the total. accurate, I cannot testify to their exactitude, Residential mortgage-backed securities were and the amounts shown should be viewed as valued at $85 billion (63 percent of the $135 approximate.19 billion), with $45 billion of subprime and Alt-A instruments (53 percent of the $85 According to information available to me billion value of RMB securities). and consistent with other summaries, the total amount of federal assistance authorized AIG was likewise highly leveraged on a to AIG through June 30, 2009, was more than consolidated basis. At year-end 2007, its $182 billion. Of that total, approximately GAAP liabilities totaled $953 billion, 10 $123 billion had been advanced in loans (the times its $96 billion in shareholder equity. amount of unpaid balances) and preferred Like other large insurance holding compa- stock investment. Authorized TARP assis- nies, AIG issued long-term debt at the tance totaled $70 billion, of which $40 billion holding company level, a strategy that can was used by the Treasury to purchase an reduce an entity’s overall cost of capital. AIG issue of AIG preferred stock (with warrants) reported $163 billion in long-term debt at and to reduce the outstanding balance of the year-end 2007 (in addition to $82 billion Federal Reserve Bank of New York (FRBNY)

12 credit facility. The remaining commitment of approximately $30 billion ($30 billion Table 2 reduced by $165 million in response to Federal Assistance to AIG through June 30, 2009 AIG’s payment of incentive compensation) (approximate, in billions of dollars) has been largely untapped. Net Net Program Announced amount amount Details Table 3 shows major recipients of direct advanced authorized funding through TARP. Exclusive of the Federal Reserve Bank of New York $30 billion untapped commitment, the Revolving credit September Original credit line $18.5 $35.0 $40 billion assistance to AIG represented facility 2008 $85 billion 11 percent of the $374 billion total (14 Purchased $39.3 billion November percent of the $289 billion total excluding Maiden Lane II $17.4 $22.5 of RMBS to terminate 2008 the $85 billion provided to the automobile AIG securities lending industry). The two largest bank recipients, Purchased $62.1 Citigroup and Bank of America, received November billion of AIGFP credit Maiden Lane III $21.0 $30.0 $50 billion and $35 billion, respectively. 2008 default swaps (notional amount) Much of the federal assistance to AIG has Reduced credit facility debt; reduced $60 been used to close out contracts with coun- Transfer of life terparties for AIG’s credit default swaps and subsidiaries June 2009 $25.0 $25.0 billion credit line to $35 billion (transaction securities lending. Table 4 lists the counter- pending) parties and amounts.20 Almost $50 billion U.S. Treasury Department (TARP) was paid to CDS counterparties ($22.5 Reduced credit facility billion from borrowing through the FRBNY November debt; reduced $85 Preferred stock $40.0 $40.0 credit facility and $27.1 billion from the with warrants 2008 billion credit line to special purpose vehicle Maiden Lane III). $60 billion Another $44 billion went to AIG’s securities Capital facility March 2009 $1.2 $29.8 lending counterparties. Thus, of the $123 Remaining lines about Total $123.1 $182.3 billion total shown in Table 4, $93.3 billion $56 billion went to AIG’s CDS and securities lending Total counterparties. Most of this amount was Commercial Balance Paper Funding $13.0 paid to banking and investment banking Facility April 29 organizations, including large amounts to Total with foreign banks, especially E.U. institutions. Commercial $136.1 Paper Three recipients received more than $10 billion: Goldman Sachs, Societe Generale, Sources: Federal Reserve, Congressional Oversight Panel, AIG Financial, and press and Deutsche Bank. Four others received releases; author’s interpretation. at least $5 billion: Barclays, Merrill Lynch, Bank of America, and UBS. Merrill Lynch and Bank of America combined assistance ents in that category were not disclosed. In totaled $12 billion. any case, the lion’s share of the assistance provided to AIG flowed directly to banking Another $5 billion was used to capitalize organizations. Maiden Lane III, which was formed to wind down AIG’s multi-sector CDO credit default Whether it was better for the government swaps. State and municipal counterpar- to rescue AIG or instead allow it to file for ties that had purchased Guaranteed Invest- bankruptcy has been debated. That debate ment Agreements from AIG received $12.1 will likely continue for years. The govern- billion. Another $12.5 billion was used for ment’s rationale for intervention, after having “maturing debt & other.” The specific recipi- allowed Lehman Brothers to fail, is that an

13 Accepting this rationale, which has been Table 3 repeated by Federal Reserve Chairman Ben Major TARP Fund Recipients through July 16, 2009 Bernanke and other high-ranking officials, Recipient Amount the Federal Reserve and U.S. Treasury judged AIG* $40 billion that it was better to undertake a de facto Other predominately insurance entities government takeover of AIG than risk the Hartford Financial($3.4 billion) $4.35 billion consequences. There can be little doubt that Lincoln National ($950 million) this judgment was affected by the desire to Top 10 banking recipients protect AIG’s banking counterparties. The Citigroup, Inc. ($50 billion) Bank of America Corporation ($35 billion) desire to protect banking counterparties with JPMorgan Chase & Co. ($25 billion) subsidiaries operating as primary dealers for Wells Fargo & Company ($25 billion) U.S. Treasury securities, and thus to maintain The PNC Financial Services Group Inc. ($15.2 billion) $190 billion Morgan Stanley ($10 billion) a stable market for new issues and broad and Goldman Sachs Group ($10 billion) liquid secondary markets for Treasury secu- Fifth Third Bancorp ($6.8 billion) rities, might also have played a significant U.S. Bancorp ($6.6 billion) role.22 Sun Trust Banks, Inc. ($6.2 billion) Other banking recipients (582 entities) $55 billion The intervention and subsequent payments Auto industry (including suppliers) $85 billion to E.U. banking counterparties reduced their Total $374 billion need to quickly raise new equity capital,

*AIG also received a commitment for an additional $29,835,000,000, which has not which may have dampened the financial been drawn as of July 16, 2009. crisis in the E.U. Financial regulators in the E.U. had accepted and, in some sense, relied Source: U.S. Department of Treasury Office of Financial Stability Transactions Report on regulation and oversight of AIG by the for the Period Ending July 16, 2009. U.S. Office of Thrift Supervision (OTS) to meet the E.U. directive that financial insti- tutions operating in the E.U. be subject to AIG bankruptcy would have further roiled consolidated oversight at the group level. Any world financial markets, creating the risk of role that this played in the U.S. government’s another Great Depression. Donald Kohn, vice decision to intervene with AIG has not been chairman of the Federal Reserve Board of disclosed. Governors, testified as follows before the U.S. Senate Banking Committee on March 5, 2009: Regulatory Oversight of AIG

Our judgment has been and continues AIG’s CDS activities were not conducted by to be that, in this time of severe regulated insurance subsidiaries. Despite market and economic stress, the AIG’s CDS problems, securities lending failure of AIG would impose unnec- problems, exposure of other investments to essary and burdensome losses on mortgage defaults, and high leverage at the many individuals, households and holding company level, it is not clear that businesses, disrupt financial markets, any of its insurance subsidiaries would have and greatly increase fear and uncer- become insolvent if the government had not tainty about the viability of our finan- intervened. cial institutions. Thus, such a failure would deepen and extend market At year-end 2008, AIG reported $35 billion disruptions and asset price declines, of surplus under statutory accounting prin- further constrict the flow of credit ciples for its general insurance segment and $25 billion for its life insurance and to households and businesses in the 23 United States and many of our trading retirement services segment. The latter partners, and materially worsen the amount reflects a change on October 1, recession our economy is enduring.21 2008, in the permissible method under statu-

14 tory accounting for other than temporary impairments for bonds, loan-backed secuti- Table 4 Payment to AIG Counterparties ties, and structured securities that increased year-end statutory surplus for the domestic CDS Securities CDS life and retirement services entities by $7 counterparties lendng counterparties 24 Counterparty from credit counterparties Total billion. from Maiden facility through through Lane III 12/31/2008 12/31/2008 A detailed analysis of whether any of AIG’s Goldman Sachs $2.5 $5.6 $4.8 $12.9 regulated insurance subsidiaries would Societe Generale $4.1 $6.9 $0.9 $11.9 have become insolvent had the federal Deutsche Bank $2.6 $2.8 $6.4 $11.8 government not intervened and the parent Barclays $0.9 $0.6 $7.0 $8.5 company had instead sought bankruptcy Merrill Lynch $1.8 $3.1 $1.9 $6.8 would need to address several complex Bank of America $0.2 $0.5 $4.5 $5.2 issues, including the potential ability of UBS $0.8 $2.5 $1.7 $5.0 capital to be moved among subsidiaries if BNP Paribus $4.9 $4.9 one or more subsidiaries were facing insol- HSBC Bank $0.2 $3.3 $3.5 Dresdner Bank vency. If one or more of AIG’s domestic life $0.4 $2.2 $2.6 AG insurers would have confronted a negative Caylon $1.1 $1.2 $2.3 capital position, it would not imply that Citigroup $2.3 $2.3 the subsidiary would have been allowed to Deutsche Z-G $0.7 $1.0 $1.7 default on its obligations if adequate capital Bank remained in other subsidiaries. ING $1.5 $1.5 Wachovia $0.7 $0.8 $1.5 Vice Chairman Kohn testified on March 5, Morgan Stanley $0.2 $1.0 $1.2 Bank of $0.2 $0.9 $1.1 2009, before the Senate Banking Committee Montreal that AIGFP Rabobank $0.5 $0.3 $0.8 Royal Bank of $0.2 $0.5 $0.7 . . . is an unregulated entity that Scotland exploited a gap in the supervi- KFW $0.5 $0.5 AIG $0.5 $0.5 sory framework for insurance International companies and was able to take Credit Suisse $0.4 $0.4 on substantial risk using the credit JPMorgan $0.4 $0.4 rating that AIG received as a conse- Banco Santander $0.3 $0.3 quence of its strong regulated Citadel $0.2 $0.2 insurance subsidiaries.25 Danske $0.2 $0.2 Paloma $0.2 $0.2 The assertion that AIGFP was unregu- Securities Reconstruction $0.2 $0.2 lated is technically incorrect and there- Finance Corp fore misleading. As noted above, and as a Landesbank B-W $0.1 $0.1 consequence of owning a savings and loan Other $4.1 $4.1 subsidiary, AIG was subject to consolidated Total $22.5 $27.1 $43.7 $93.3 Equity in Maiden regulation and oversight by the OTS, and it $5.0 was recognized as such for the purpose of Lane GIAs held by $12.1 meeting the 2005 E.U. regulatory criterion municipalities for group supervision. Maturing debt $12.5 and other At the same hearing, OTS Acting Director Grand Total $122.9 Scott Polakoff testified as follows: Source: AIG Discloses Counterparties to CDS, GIA, and Securities Lending Transactions, March 15, 2009.

15 OTS conducted continuous consoli- effective capital requirements for risky loans dated supervision of the group, would have discouraged excessive expansion including an on-site examination of credit on easy terms and the associated team at AIG headquarters in New overbuilding and rapid escalation of housing York. Through frequent, on-going prices.27 dialog with company management, OTS maintained a contempora- Culpability of the OTS notwithstanding, neous understanding of all material AIG’s major counterparties were regulated by parts of the AIG group, including U.S. and foreign banking regulators. Broad their domestic and cross-border regulatory authority encompasses responsi- operations.26 bility for monitoring an institution’s relation- ships with counterparties that could allow it Polakoff then recounted numerous meetings to take on excessive risk. If, hypothetically, with AIG’s senior management and inde- a domestic or foreign reinsurance company pendent auditor. He indicated that in March were to expand to the point where its finan- 2006 the OTS provided AIG’s board with cial distress seriously weakened the finan- written recommendations on risk manage- cial condition of U.S. licensed insurers, state ment oversight and related issues, including insurance regulation would almost certainly discussion of significant weaknesses at AIGFP. take the primary blame. Even apart from the OTS and possible reliance of regulators on Federal banking The OTS was also responsible for regulating AIG’s top financial rating, federal banking regulators bear Countrywide, Washington Mutual, and regulators bear significant responsibility for significant Indy Mac, large mortgage finance organiza- not recognizing the of allowing regu- responsibility for tions that eventually failed and were merged lated banking entities to (1) buy extensive not recognizing with or acquired by other entities with FDIC amounts of credit protection from AIG, assistance. The ineffectiveness of federal OTS and (2) provide large amounts of securities the risk of allowing regulation at preventing those failures or the lending collateral to AIG. regulated banks to AIG crisis does not indicate that the enti- buy large amounts ties were unregulated, nor does it imply that AIG’s Post-Intervention Ability to Write of credit protection state insurance regulation was to blame for Business AIG’s breakdown. from AIG. AIG’s insurance subsidiaries have continued

to write business following the federal inter- If the financial crisis in general and the AIG vention. The long-run effects of the inter- crisis in particular are to be blamed on inef- vention and the ability of AIG’s insur- fective regulation, the blame should reflect ance subsidiaries to prosper are not clear. the substantial evidence of fundamental A number of AIG’s U.S. commercial prop- failures in U.S. and foreign banking regula- erty/casualty insurance competitors have tion, including in the U.S. by the OTS, the alleged that AIG’s domestic commercial Office of the Comptroller of the Currency, insurers have priced some renewal busi- the FDIC, the SEC, and the Federal Reserve. ness very aggressively in order to retain Banking regulation permitted and prob- clients. A Government Accountability Office ably encouraged high leverage, aggressive investigation of the allegations, which investment strategies, inadequate capital included discussions with regulators, under- requirements for risky loans and securitiza- writers, and brokers, failed to document the tions, and complex off-balance sheet vehi- allegations.28 cles, often financed by commercial paper, all taking place within the framework of A detailed analysis of AIG’s experience government deposit insurance and “too since the intervention might be informative big to fail” (TBTF) policy. In addition to about the extent to which federal backing reducing financial institutions’ losses, higher may have helped AIG retain business for

16 both its property/casualty and life insur- Figure 2 ance operations. Figure 2 shows year-over- U.S. and AIG Commercial Property/Casualty Insurance year percentage premium revenue growth Premium Growth for AIG’s domestic commercial property/ Year-Over-Year Percentage Changes casualty business from the first quarter of 2008 through the first quarter of 2009.29 It -25%-25% also shows nationwide commercial prop- -22.1% erty/casualty insurance premium revenue -20% growth (using data from A.M. Best). Nation- -20% -18.3% wide premium revenues fell throughout the -14.9% period due to price declines and reduced -15%-15% economic activity. AIG’s declines were much greater during each quarter, especially -10%-10% during the quarter following the September -7.8% -7.3% 2008 intervention. The extent to which the -7.0% -6.9% -5.0% more pronounced premium declines at -5%-5% AIG reflect loss of customers versus lower -1.5% premium rates is not known. -0.2% -0%0% 2008.1 2008.2 2008.3 2008.4 2009.1 Systemic Risk and the Crisis ■ AIG There is no generally accepted definition of ■ U.S. “systemic risk” or agreement on its impor- Source: AIG financial reports and A.M. Best Company. Author’s calculations. tance and scope. The term generally is used to connote situations with extensive interde- pendencies or “interconnectedness” among firms, and an associated risk of conta- similar problems at other institutions). The gion and significant economic spillovers.30 delayed response to the common shock might A group of financial market executives give the appearance of contagion. and academics, for example, has defined systemic risk as “the risk of collapse of an The economics literature has identified at least entire system or entire market, exacerbated four sources of systemic risk: by links and interdependencies, where the failure of a single entity or cluster of entities 1. The risk of asset price contagion, can cause a .”31 where a shock causes one or more financial institutions to have to sell The risk of common shocks to the economy, large amounts of assets at temporarily such as widespread reductions in housing depressed prices (e.g., through “fire prices or changes in interest rates or foreign sales”), thereby further depressing exchange rates, which have the potential prices and market values of institu- to directly harm large numbers of people tions that hold similar assets;32 and firms, is distinct from the economist’s concept of systemic risk because it does not 2. The risk of counterparty contagion, depend on interdependency-transmitted where shocks to some firms make contagion. The full effects of such shocks them unable to honor commitments might not be recognized immediately. to counterparties, thereby causing Instead, evidence of the effects on a few some of the counterparties to likewise firms may lead to reevaluation and informa- default on their commitments, with tion that other firms have also been directly repercussions that cascade through affected (e.g., recognition of asset problems financial markets; at one institution leads to recognition of

17 3. The risk of contagion due to uncer- gage-related securities as the new informa- tainty and opacity of information, tion was reflected in prices. While there where the revelation of financial apparently were some elements of counter- problems at some institutions creates party contagion, asset price contagion, and uncertainty about the effects on uncertainty/opacity contagion, the principal counterparties and whether other problem was the decline in security values. institutions face similar problems, so AIG was heavily exposed to the subprime that parties become reluctant to trade crisis and the bursting of the housing price until further information becomes bubble. Whether AIG’s CDS portfolio and available; and securities lending actually presented signifi- cant risk of contagion has been and will be 4. The risk of irrational contagion, debated. Critics of the bailout stress that where investors and/or customers providing selective assistance to individual withdraw funds without regard to firms is problematic, in part because it whether specific institutions are at undermines incentives for safety and sound- risk. ness in the long run. They argue that the slow and painful process of bankruptcy is Depending on the circumstances, each generally preferable, especially for non-bank source of systemic risk can be asserted to institutions.34 An AIG bankruptcy justify government intervention to reduce may or may not adverse effects on the overall economy, such Relatively little is known about the extent to have had significant as a sharp contraction in bank credit. Each which an AIG bankruptcy would have had source of risk also can be asserted to justify significant adverse effects beyond its coun- adverse effects on bailing out an individual firm to reduce terparties or the extent to which its coun- its counterparties. adverse effects on other parties, as opposed terparties had hedged their bets with AIG or Goldman Sachs, for to allowing the firm to file for bankruptcy. In otherwise reduced their risk. CDS protec- example, reported contrast, the risk of common shocks would tion buyers have some ability to diversify that its exposure to seldom justify selective intervention to save across different sellers, and they are able to an AIG default was an individual company. enter into offsetting trades. Goldman Sachs, for example, reported that its exposure to an negligible. A significant body of academic research has AIG default was negligible.35 attempted to identify possible contagion in previous episodes of financial turmoil, and A failure to rescue AIG and funnel $123 dozens if not hundreds of studies of conta- billion to its counterparties (Table 4) would gion in the current crisis can be expected. have weakened their financial condition, A cursory review of prior research, which forcing them to sell more assets and reducing largely predates the growth of credit default their ability to invest and make loans. Some swaps and complex securitizations, yields of AIG’s E.U. banking counterparties would very little evidence of irrational contagion have needed to raise more capital or signifi- and little evidence of contagion related to cantly reduce their risk exposure. Although counterparty risk, asset prices, or uncer- many more of AIG’s insurance customers tainty/opacity. This includes studies of the might have terminated or declined to renew early 1990s junk bond/real estate crisis in the their policies, by itself that would not repre- life insurance sector (see below).33 sent systemic risk.

The AIG crisis and general financial crisis Systemic Risk in Insurance were precipitated by the bursting of the housing price bubble and attendant increases Notwithstanding whether AIG’s unique in actual and expected mortgage defaults, circumstances created systemic risk, the which greatly reduced the values of mort- question arises as to whether insurance companies typically pose systemic risk.36

18 The general consensus is that systemic discipline for financial institutions to be risk is relatively low in insurance markets safe and sound. We generally want parties to compared with banking, especially for prop- avoid dealing with undercapitalized financial erty/casualty insurance, in part because institutions. Guarantees reduce the penal- insurers hold greater amounts of capital in ties for doing so. Thus, there is a basic policy relation to their liabilities, reducing their tradeoff. Stronger guarantees reduce systemic vulnerability to shocks.37 risk but increase . Given this tradeoff, greater systemic risk favors stronger To be sure, low probability events with large government guarantees because of the greater losses, such as severe hurricanes, can simul- potential for adverse effects on real economic taneously damage many property/casualty activity. Greater systemic risk also favors insurers. The impact can be spread broadly tighter regulation in view of the additional among insurers through product line and moral hazard induced by stronger guarantees. geographic diversification and reinsurance, which creates contractual interdependence As noted above, bank depositor and creditor among insurers. Large insurance losses and runs might threaten the economy’s payment asset shocks can temporarily disrupt prop- system. Banking crises have the potential erty/casualty insurance markets, sometimes to produce rapid and widespread harm to contributing to market “crises” with some economic activity and employment. This Government adverse effect on real economic activity. systemic risk provides some rationale for rela- Even so, there is little likelihood and no tively broad government guarantees of bank guarantees protect evidence of significant contagion associated obligations and correspondingly stricter regu- consumers and help with major events. lation, including stronger capital require- reduce systemic risk ments. The need for stronger capital require- by deterring runs. Systemic risk is larger for life insurers (e.g., ments in turn causes banks to seek ways of As a by-product, due to a sharp fall in asset prices) given evading the requirements and to lobby for their higher leverage, especially when poli- their relaxation. The first and second Basel they create moral cyholders seek to withdraw funds following accords on bank capital regulation reflect this hazard: they reduce large negative shocks, thus causing some pressure. market discipline insurers to unload assets at temporarily for financial depressed prices. However, although a few Because insurance, especially property/casu- institutions to be life insurers that had heavily invested in junk alty and health insurance, poses much less safe and sound. bonds or commercial real estate were subject systemic risk, there is less need for broad to policyholder runs in the early 1990s, government guarantees to prevent poten- there is no evidence that financially strong tially widespread runs that would destabi- insurers were affected.38 Moreover, shocks lize the economy. Insurance guarantees have to life insurers do not threaten the econo- appropriately been narrower in scope than my’s payment system, as might be true for in banking, and market discipline is gener- commercial banks. ally strong. Capital requirements have been much less binding — insurers commonly More generally, and as I have emphasized in have held much more capital than required by prior publications and congressional testi- regulation. Because insurance capital require- mony, insurance markets are fundamentally ments are much less constraining, reducing different from banking. Sensible regulation, incentives for regulatory arbitrage and other including government guarantees of banks’ evasion, the need for accurate capital require- and insurers’ obligations, should recognize ments has been less important. In the case the differences. Government guarantees of mortgage/bond insurance, the monoline protect consumers and help reduce systemic structure and contingency reserves required risk by deterring runs. As a by-product, they by insurance regulation also have reduced create moral hazard: they reduce market potential systemic risk by preventing spillovers

19 on other types of insurance and reducing to apply to most financially distressed leverage. non-bank entities.

Proposed Regulation of • A Financial Services Oversight Council “Systemically Significant” Insurers would be established to facilitate coor- dination and information sharing The Treasury Proposal among regulatory agencies, study On June 17, 2009, the U.S. Treasury released financial sector trends and regulatory a white paper outlining proposals for finan- issues, and advise the Federal Reserve cial regulatory reform.39 The white paper on the identification and appropriate attributes much of the blame for the finan- regulation of Tier 1 FHCs. cial crisis to the failure of large, highly lever- aged, and interconnected financial firms, • An Office of National Insurance would such as AIG. In contrast to the reform blue- be formed to monitor and analyze the print released a year earlier by the Bush insurance industry and help identify to administration, the Treasury’s 2009 white the Federal Reserve firms that should be candidates for Tier 1 FHC status. It A U.S. Treasury paper does not propose optional federal chartering of insurance companies. However, would carry out certain federal func- proposal would give the white paper does include several key tions, such as administration of the the Federal Reserve proposals that would affect insurance:40 Terrorism Risk and Insurance Act, and broad authority it would represent U.S. insurance inter- ests internationally with authority to to regulate as a • The Federal Reserve would have enter into international agreements. Tier 1 Financial broad authority to regulate as a Tier 1 Financial Holding Company (FHC) Holding Company “any firm whose combination of size, The Treasury proposal also expresses support “any firm whose leverage, and interconnectedness could for six principles for insurance regulation, combination of pose a threat to financial stability if including (1) effective systemic risk regula- size, leverage, and it failed.” The authority would not be tion, (2) strong capital standards, (3) “mean- limited to firms that own banks or ingful and consistent” consumer protection, interconnectedness (4) increased national uniformity through could pose a threat even domestic financial firms. The Fed would have discretion to classify firms either optional federal chartering or state to financial stability as Tier 1 FHCs, which, along with all action, (5) improved regulation of insurers if it failed.” of its subsidiaries, would be subject and affiliates on a consolidated basis, and (6) to its authority, regardless of whether international coordination. those subsidiaries had a primary regulator. Office of National Insurance Act of 2009 Following release of its white paper, the Trea- • A new regime would be created for sury on July 22, 2009, proposed specific legis- resolution, patterned after FDIC lation, “Title V - Office of National Insur- resolution procedures, of financially ance Act of 2009,” for creating the Office distressed bank holding companies of National Insurance (ONI) to “monitor and Tier 1 FHCs in the event that all aspects of the insurance industry.”41 As “a disorderly resolution would have proposed in the white paper, the ONI would serious adverse effects on the financial recommend to the Federal Reserve which system or the economy.” The Treasury insurers, due to systemic risk exposure, would have final authority for using should be designated Tier 1 FHCs and regu- the regime with approval required by lated by the Federal Reserve. two-thirds of Federal Reserve board members and two-thirds of the FDIC The ONI would also collect and analyze board. The proposal emphasizes that normal bankruptcy would be expected 20 information on the insurance industry, with Section 201 of H.R. 1880 would require the broad subpoena power to compel insurers President to designate a federal agency (but to produce data in response to its requests. not ONI) to be a systemic risk regulator The Treasury would be authorized to nego- for systemically significant state and feder- tiate and enter into “International Insurance ally chartered insurers. The agency would Agreements on Prudential Measures” on have authority to participate in examinations behalf of the United States. The ONI would of insurers with functional regulators and have broad authority to preempt any state recommend actions to avoid adverse effects regulations that were deemed inconsistent on the economy or financial conditions. It with such agreements. could also force an insurer to become federally chartered. The information collecting, international representation, and preemption features of Section 202 would establish a Coordinating the Treasury bill are broader but similar in National Council for Financial Regulators to concept to a bill introduced on May 22, 2009, serve as a forum for financial regulators to by Representative Paul Kanjorski (D-Pa.), collectively identify and consider financial “The Insurance Information Act of 2009” regulatory issues, including the stability of (H.R. 2609). In contrast to the Treasury financial markets. The council would promote bill, H.R. 2609 does not deal with systemic the financial strength and competitiveness of Any institution risk authority. It would create an Office of U.S. financial services, develop early warning designated as Insurance Information (OII) to collect and systems to detect weaknesses, recommend “systemically analyze data on insurance to help Congress coordinated actions, and develop model significant” would make decisions regarding insurance. The supervisory policies for national and state OII would “serve as a liaison between the regulators. almost surely be Federal Government and the individual and regarded as too big several States regarding insurance matters Arguments Against Creating a Systemic Risk to fail. This would of national importance and international Regulator reduce market importance.” It would establish U.S. policy The large U.S. investment banks that survived discipline and on international insurance issues. It could the financial crisis have all become bank aggravate moral enter into agreements that “are substan- holding companies and are, therefore, already tially equivalent to regulation by the States hazard, making regulated by the Federal Reserve. There are of the comparable subject matter.” It would future financial strong arguments against creating a systemic preempt state law inconsistent with such risk regulator that would be able to designate problems more agreements. insurers and other non-bank financial institu- likely. tions as being subject to comprehensive regu- The Bean-Royce Optional Federal Charter Bill lation and oversight by the Federal Reserve or Representatives Melissa Bean (D.-Ill.) and other agency.42 Edward Royce (R-Calif.) introduced “The National Insurance Consumer Protection • Any institution designated as “systemi- Act” in April 2009 (H.R. 1880). The bill cally significant” would almost surely be would create an optional federal chartering regarded as too big to fail. This would system for insurance (discussed further reduce market discipline and aggravate below). An Office of National Insurance moral hazard, making future financial (ONI) would be established within Trea- problems more likely. sury to regulate insurers that chose federal regulation, including the establishment of a • Because of implicit, if not explicit, national guaranty system for such insurers government guarantees of its obliga- that would also be required to participate in tions, any institution designated as state guaranty systems. systemically significant would have a lower cost of attracting capital than

21 its non-systemically significant • It does not adequately consider the competitors.43 potential benefits and costs of creating a systemic risk regulator. • Greater capital requirements and tighter regulation for institutions • It does not consider the failures of designated as systemically signifi- federal regulation of large banking cant could reduce moral hazard and organizations that contributed to the the potential competitive advan- financial crisis. tages conveyed by the systemically significant designation. But differen- • It largely ignores the regulated insur- tial capital requirements and regula- ance sector’s comparatively modest tion would necessarily involve two role in the crisis. risks. One possibility is that compa- nies designated as systemically signifi- • It provides no guidance for limits cant would face excessive burdens on the scope of discretionary federal Once the systemic and costs. The other possibility, which authority to intervene in the regulator seems more likely given the history sector in particular and the economy has designated of bank capital regulation and strong in general. an institution incentives for regulatory arbitrage, is that changes in capital requirements Moreover, given lessons from the current as systemically and regulation would not be sufficient crisis and the earlier savings and loan crisis, significant, it would to prevent an increase in moral hazard. it is hardly certain that a systemic risk regu- likely have an lator would be an effective means of limiting incentive to prop • Once the systemic risk regulator has risk in a dynamic, global environment. Even up the institution designated an institution as systemi- without any increase in moral hazard, it cally significant, it would likely have could be ineffective in preventing a future if it experienced an incentive to prop up the institution crisis, especially once memories fade. The problems, even if it experienced problems, even if the financial crisis underscores (1) the imper- if the particular particular problems had little potential fect nature of federal regulation of banks problems had for systemic consequences. and related institutions, (2) the necessity of little potential renewed vigilance in banking oversight and for systemic • The threat of being designated as capital requirements, and (3) the desirability systemically significant and subject to of encouraging additional market discipline consequences. regulation by a federal systemic risk in banking. regulator at a future date would create significant uncertainty for large, non- The federal government was able to inter- bank financial institutions that could vene in AIG and limit potential contagion distort their financial and operating without having had the authority to regulate decisions in undesirable ways. AIG ex ante. The question arises: What would the Federal Reserve have done differently if it A counter-argument is that the AIG melt- had systemic risk authority before and during down and federal intervention make a prima the crisis?44 The answer is hardly clear and has facie case that some sort of federal regula- not been provided. tory authority is required for large and inter- connected non-bank financial institutions. In short, creating a systemic risk regulator This assertion is not compelling for several for insurers and other non-bank institutions related reasons: designated as systemically significant would not be good policy. It would instead illustrate the adage that “bad policy begets bad policy.”

22 The Crisis and and implementation of international insur- Optional Federal Chartering ance accounting and/or capital standards). In contrast to the early 1970s and early 1990s, The possible creation of a system of optional when temporary increases in the frequency federal chartering (OFC) for insurance and severity of insurance company insol- companies has been debated for more than vencies motivated OFC proposals, pre-AIG two decades.45 The financial crisis and AIG pressure for OFC during this decade was not bailout have changed the context of the primarily motivated by solvency concerns. debate, if not the key issues. The main characteristics of state solvency The OFC Debate Pre-Crisis regulation — regulatory monitoring, controls Prior to the events of 2008, pressure for on insurer risk taking, risk-based capital OFC or other fundamental changes in state requirements, and limited guaranty fund insurance regulation of property/casualty protection — are sensible given the ratio- and life/annuity insurers focused on three nales for regulating solvency and for partially main concerns: protecting consumers against the conse- quences of insurer default. As noted earlier, State guarantees of 1. Costs and delays associated with regu- consistent with lower systemic risk, state guar- latory approval of policy forms in 55 antees of insolvent insurers’ obligations are insolvent insurers’ different jurisdictions; limited, which reduces moral hazard and helps obligations to preserve market discipline. Customers, espe- policyholders is 2. Costs, delays, and possible short-run cially business insurance buyers, and agents/ limited, which suppression of rates below insurers’ brokers generally pay close attention to insol- vency risk. Ex post funding of state guaranty reduces moral projected costs associated with prior hazard and regulatory approval of insurers’ rate association obligations by assessments against changes; and surviving insurers’ obligations is appropriate. preserves market Insurers can respond effectively to such assess- discipline. Ex post 3. Restrictions on insurers’ underwriting ments without pre-funding. Ex post funding funding provides (risk selection) decisions and risk also provides incentives for financially strong incentives for classification. insurers to press for effective regulatory 46 financially strong oversight. The pricing and underwriting issues are insurers to press for primarily relevant for property/casualty However, as I and many other economists effective regulatory insurers (and health insurance). Regula- have emphasized for two decades, continued oversight. tion of policy forms is the overriding issue government interference with insurers’ legiti- for life/annuity insurers. Executives of many mate product and pricing decisions is inef- 47 large life insurers support federal chartering ficient and counterproductive. Despite for this reason and because a federal regu- meaningful modernization initiatives by the lator might better represent their compa- states and the NAIC, the persistence of such nies’ interests before Congress. OFC also is policies leads to legitimate inquiry about supported by executives of many large prop- whether federal intervention through OFC erty/casualty insurers. More generally, OFC or some other mechanism is an appropriate is viewed by many as a potential mechanism means to eliminate such practices and further to achieve desirable regulatory moderniza- encourage any desirable increases in unifor- tion with suitable deregulation, including mity of regulation. improved ability to deal with multi-juris- dictional issues within the U.S. (such as The main arguments against OFC of insurers appropriate policy regarding terrorism risk are: (1) the states have done a reasonably and insurance) and internationally (such as good job on many dimensions, including reinsurance regulation and the development solvency regulation; (2) the possible benefits

23 from optional federal chartering are uncer- within the first category. That proposal could tain, and relatively little might be gained by substantially override state solvency regulator creating an expensive, new federal bureau- prerogatives, while specifically exempting cracy; (3) OFC could create an unequal any preemption of state laws or procedures playing field between large multistate dealing with insurance rates, underwriting, insurers and small insurers that are reason- coverage requirements, or sales practices. The ably satisfied with state regulation and would otherwise broad preemptive authority would face relatively high costs of switching char- represent a significant step toward federal ters; and, more broadly, (4) the potential chartering and regulation. risks and costs of OFC are large compared with the uncertain benefits. Do the Financial Crisis and AIG Intervention Justify OFC? The history of federal deposit insurance and Creation of a systemic risk regulator TBTF policy suggests that, either initially notwithstanding, do the financial crisis and or later on, OFC could expand govern- AIG bailout significantly strengthen the case The Treasury’s ment guarantees of insurers’ obligations, for enacting some form of OFC of insurance proposed thereby undermining market discipline and companies? Some observers essentially assert incentives for safety and soundness. Even if legislation for that the AIG bailout seals the case for either OFC were to reduce the scope of insurance creating an Office OFC or OFC combined with mandatory price regulation initially, it could ultimately of National federal chartering (MFC) for systemically produce broader restrictions on pricing and significant insurers.49 Enactment of the Trea- Insurance could underwriting at the federal level to achieve sury’s proposal that the Federal Reserve regu- substantially political or social goals. Broad, federal late non-bank institutions it designates as override state restrictions would increase cross-subsidies systemically significant and the Bean-Royce among policyholders, inefficiently distort solvency regulator OFC bill would achieve the latter result. The policyholders’ incentives to reduce the risk prerogatives, basic argument for such a regime seems to of loss, and increase risk to federal taxpayers be that if the federal government might have while specifically if political pressure led to inadequate rates to intervene in the event that a large and exempting any (e.g., for windstorm coverage in coastal systemically significant financial institution preemption of state areas). OFC also poses an inherent risk of with extensive insurance operations becomes adverse unexpected consequences, no matter laws dealing with financially distressed (e.g., as is alleged to how carefully and narrowly initial legislation insurance rates, have been essential for AIG), then it should was crafted. underwriting, have regulatory authority over such institu-

tions ex ante, and smaller and/or less systemi- coverage Two alternatives to OFC might have the cally significant competitors should have the requirements, or potential for improving insurance regulation option to choose federal regulation. sales practices. with less risk: (1) selective federal preemp- tion of inefficient state regulations, such as The chain of reasoning might be depicted as prior approval rate regulation in competi- follows: tive markets and inefficient impediments to nationwide approval of certain products, and (2) allowing insurers to choose a state Enact of OFC Federal Reserve with MFC for AIG Crisis for primary regulation with authorization to and Treasury systemically operate nationwide primarily under the rules Intervention risky insurers of that state.48

This chain of reasoning is unconvincing. The Treasury’s proposed legislation for First, the asserted necessity for MFC of creating an Office of National Insurance insurers designated as systemically signifi- with broad authority to enter into interna- cant is subject to all of the arguments against tional agreements on prudential regulation a systemic risk regulator for non-bank insti- and preempt state regulation does not fall

24 tutions outlined in the previous section. There can be no presumption that federal Second, there have been no compelling regulation of AIG’s insurance operations arguments or evidence that the financial would have prevented or mitigated risk taking crisis has fundamentally altered the poten- at AIG, or that OFC with or without manda- tial benefits and costs of OFC for insurers. tory federal chartering for large insurance organizations would mitigate any role of AIG’s problems cannot be primarily attrib- insurance in some future financial crisis. It’s uted to any insurance regulatory failure. just as likely, or perhaps even more likely, that Given what we currently know, AIG likely federal regulation of large insurers would have would have been able to largely, if not further increased risk in ways that would have completely, meet its obligations to policy- posed a greater threat to policyholder claims. holders without federal intervention, with state insurance guaranty funds serving as a Implications for potentially important backup if it could not. Insurance Regulation While there is still uncertainty, I know of no evidence that AIG’s life subsidiaries’ assets Lessons to be drawn from the financial crisis There can be no and AIG intervention do not include the need remain vulnerable to large write-downs and/ presumption that or that its property/casualty subsidiaries are for a systemic risk regulator with authority sitting on a mountain of liability claims that over insurers and non-bank institutions that federal regulation are not reflected in its reported liabilities would be designated as systemically signifi- of AIG’s insurance (loss reserves). cant. The crisis and intervention also do not operations would fundamentally strengthen arguments for have prevented The alternative scenario — where insol- either optional or mandatory federal regula- or mitigated risk vency of AIG subsidiaries would require tion of insurance. multi-billion dollar assessments under the taking at AIG, or state guaranty system — would substantially Creating some form of federal insurance would mitigate any increase pressure for federal regulation. information office to provide information, role of insurance Even then, however, a strong case for federal serve as a liaison on insurance issues with in some future insurance regulation in response to the crisis Congress, and represent the United States in financial crisis. The international insurance regulatory forums would have to explain why the following federal crisis and scenario would represent sensible policy: would be sensible. The creation of a federal council to monitor domestic and interna- AIG intervention Federal tional financial institutions and the economy do not strengthen Lax monetary regulation policy and Subprime for developments that could pose systemic (Fed, OCC, arguments for lax bank/ mortgage/ OTC, and SEC) risk and potentially lead to a future crisis thrift lending financial crisis fails to limit either optional or standards could also be useful. Such an entity could be risk taking mandatory federal empowered to collect and analyze informa- Fed and regulation. Federal tion about risk and disseminate it broadly and Treasury regulation intervene to to advise regulators and the Treasury about expands to protect AIG’s encompass activities that might pose systemic risk. The banking large insurers counterparties focus could be on identification of intercon- nected activities for which the dangers of That case has not been made, and the ques- contagion from a catastrophic event could tion arises: In view of what happened at outweigh the benefits those activities provide Citibank, Bank of America, and other bank in the form of better diversification, scale and investment bank holding companies, how and scope economies, and innovation. The would federal regulation of AIG before the entity would need to have broad expertise in crisis specifically have prevented or mitigated financial institutions and markets, including its problems? insurance.

25 The question of whether regulatory Of all the regulatory challenges authority for resolving financially distressed, that have emerged out of this crisis, non-bank institutions should be expanded I view the TBTF problem and deserves much more study before being the TBTF precedents, now fresh given serious consideration. Recent events do in everyone’s mind, as the most not justify broad authority for the FDIC or threatening to market efficiency some other federal agency to selectively seize and our economic future.50 and resolve financially troubled insurance organizations or other non-banking organi- Commercial banks, investment banks, zations, thereby superseding bankruptcy law savings and loans, mortgage originators, or state insurance liquidation procedures. subprime borrowers, and AIG obviously I do not know whether the Federal Reserve placed heavy bets on continued apprecia- and Treasury’s judgment call on the AIG tion of housing prices. The losses have been intervention was correct. Reasonable people huge and widespread. A simple explana- can disagree about the specific probability tion for much of the aggressive risk taking and magnitude of potential harm to the was that the potential gains and losses were economy that would justify such action, and asymmetric.51 If housing prices continued on how great the risk was in the AIG case. upwards, or at least didn’t fall, participants But the threshold for such action should be could achieve large profits. If housing prices Recent events do truly extraordinary. Formal expansion of stabilized, or even fell, the losses would be not justify broad federal resolution authority to encompass borne largely by other parties, including authority for the non-bank financial institutions would make taxpayers. The extended period of historically FDIC or some other future interventions more likely and very low interest rates encouraged high leverage likely be combined explicitly or implicitly and fueled risky borrowing, lending, and federal agency to with authority to regulate non-banks, at least investment. selectively seize and those deemed systemically significant. resolve financially Implicit guarantees of Fannie Mae and troubled insurers or The general financial crisis and AIG inter- Freddie Mac debt lowered their financing other non-banking vention have implications on several other costs, amplifying credit expansion. Commer- organizations. key dimensions that are relevant to this Issue cial bank deposit insurance and implicit Analysis and that should be considered by guarantees of bank obligations encouraged current regulators and when developing any high leverage and risky mortgage lending new regulatory initiatives. They include: (1) and investment, especially given strong pres- market discipline and the TBTF problem, sure from Congress and the Department of (2) banks and insurers’ capital requirements, Housing and Urban Development for more and (3) holding company–subsidiary rela- subprime lending. The shift from partner- tionships and possible segmentation of risky ships to corporate ownership of invest- activities. ment banks encouraged them to take greater risk in relation to capital. The SEC agree- Market Discipline and TBTF Policy ment on consolidated supervision of the top investment banks may have allowed them Regulatory discipline or a lack thereof to increase leverage as they took on more notwithstanding, a lack of market discipline subprime-mortgage exposure. AIG facilitated represents one of the key underlying causes investment in mortgage securitization by of the crisis, and the subsequent expansion domestic and foreign banking organizations of TBTF policy the biggest danger. In his by selling low-cost protection against default remarks at the American Enterprise Institute risk. Subprime mortgage originators were on June 3, 2009, for example, Alan Green- often new entrants who loaned billions of span opined: dollars at very low initial interest rates, with

26 little or no money down, and with weak Capital Requirements underwriting standards. Financial regulatory reform proposals gener-

ally advocate or at least suggest that bank Given what we know about the causes of capital requirements be increased to limit risk the housing bubble and ensuing financial taking. It has been suggested that relatively crisis, a primary objective of legislative and higher capital requirements be imposed on regulatory responses should be to encourage systemically significant organizations, with market discipline as a means to promote progressively increasing requirements as an prudence, safety, and soundness in banking, entity’s size and potential for systemic conse- insurance, and other financial institu- quences grows. Another suggestion is to adopt tions. An overriding goal of any changes rules that would require banks to accumulate in financial regulation in response to the additional capital in good years to serve as an AIG anomaly should be to avoid extending additional buffer in bad years, thus reducing explicit or implicit TBTF policies beyond the severity of financial shocks and associated banking. While it could well be difficult to lending contractions. significantly strengthen market discipline, ill-thought-out responses to the crisis could Regardless of the merits and feasibility of easily weaken it by expanding TBTF policy. such suggestions for banking organizations, The creation of a systemic risk regulator and Movement toward the financial crisis does not imply the need expanded federal authority over financially for any fundamental changes in U.S. insur- applying bank distressed insurers and other non-bank ance company capital requirements. Insur- models of capital institutions would very likely undermine ance capital requirements should continue regulation to market discipline and protect even more to recognize the distinctive nature of insur- institutions, investors, and consumers from insurance, as ance markets. Given limited systemic risk and the downside of risky behavior. illustrated by potential for contagion, government guar- some proposals for antees of insurers’ obligations are appropri- Systemic risk aside, any debate over OFC ately narrower in scope than in banking, and federal insurance of insurance companies should likewise market discipline is reasonably strong. Strong regulation and recognize the fundamental importance of market discipline favors capital requirements by the Solvency avoiding expanded government guaran- that generally are easily met by the bulk of tees of insurers’ obligations. This might II initiative in the insurance companies, reducing potential be achieved in principle under OFC by E.U., should be undesirable distortions of sound companies’ requiring federally chartered insurers to operating decisions and incentives for evading resisted. participate in the state guaranty system and/ the requirements. or by designing federal guarantees along the lines of existing state guarantees. The design Pressure for and movement toward applying of any government guarantees also might bank models of capital regulation to insur- be tailored in principle to help encourage ance, as illustrated by some proposals for additional market discipline. It should be federal insurance regulation and by the recognized from the outset, however, that a Solvency II initiative in the E.U., should be monopoly federal guaranty program might resisted. As the financial crisis would appear ultimately ensue with optional federal regu- to highlight, those models reflect excessive lation. That result could very easily under- optimism concerning the ability of seem- mine market discipline, requiring tougher ingly sophisticated modeling and regulatory capital requirements, which companies oversight to substitute for market discipline, would fight, and which, if implemented, and they pay too little attention to promoting would produce some undesirable distortions market discipline. Any new regulatory initia- in companies’ decisions, and provide incen- tives regarding insurance in the United States tives for them to mitigate the effects of the should avoid this path. requirements in innovative ways.

27 Holding Companies and Risk Segmentation insulating operations of commercial banking and insurance subsidiaries from potentially While the details will likely change, large harmful effects of integration. insurance holding companies with banking-

related subsidiaries in the U.S. and/or abroad The financial crisis and the general issue of will remain subject to some form of federal the permissible scope of financial institu- regulatory authority at the holding company tions’ activities also brings attention to the level. Regarding supervision of U.S. insur- possibility that in some instances a mono- ance subsidiaries, state regulators and the line structure, such as that used for mort- NAIC have an elaborate statutory and gage/bond insurers may be advantageous to administrative framework designed to deter limit the spread of financial shocks.52 In this parent holding companies that experience regard, detailed study is desirable of mort- financial difficulty from draining funds from gage/bond insurers’ performance during the their insurance subsidiaries. Detailed study is crisis, including the effectiveness of contin- needed of how this system performed in the gency reserve requirements in lessening current crisis, the potential risks of securities their vulnerability to increases in mortgage lending and parent company debt finance, defaults. Study is also needed to determine and whether any additional changes (beyond the extent to which such defaults adversely State regulators and recent revisions in reporting requirements affected mortgage/bond insurers’ ability to the NAIC have an for securities lending) should be considered provide municipal bond guarantees and of to strengthen oversight of parent-subsidiary elaborate statutory the effects on entities that relied on those relationships. and administrative guarantees for rolling over their funding. framework Such study would help inform policymakers More broadly, the financial crisis highlights about strengths and weakness of the current designed to deter the need for continued analysis and under- structure of mortgage/bond insurers, and parent holding standing of the benefits and costs of allowing possibly shed light on whether the structure entities to engage in diverse financial services companies might be adopted for other risks with cata- under common ownership, and of the best that experience strophic exposure. financial difficulty ways to structure such organizations to achieve efficiencies from interconnectedness Conclusion from draining while limiting systemic risk. Former Federal funds from Reserve Board Chairman Paul Volker and a The AIG crisis and general financial crisis their insurance number of other observers have suggested, were precipitated by the bursting of the subsidiaries. for example, that the financial crisis requires housing price bubble and attendant increases re-examination of the possible advantages of in actual and expected mortgage default separating commercial banks’ core functions rates. The predominant problem was the of deposit-taking and lending from other attendant decline in values of loans and financial activities. mortgage-related securities. The AIG crisis was heavily influenced by credit default Even if a compelling case could be made swaps written by AIG Financial Products, for such separation to limit systemic risk not by insurance products written by regu- and the ability of bank holding companies lated insurance subsidiaries. AIG also ran to leverage deposit insurance and TBTF into major problems with its life insurance policy, it is extraordinarily unlikely that the subsidiaries’ securities lending program. The permitted integration of banking and other holding company was highly leveraged, and financial service activities under common its overall investment portfolio was signifi- ownership would be rolled back significantly. cantly exposed to reductions in the value of Nevertheless, the fundamental question mortgage-related securities. remains concerning how to structure and oversee financial integration to best achieve If the financial crisis and AIG intervention efficiencies while limiting systemic risk and are to be blamed on ineffective regulation,

28 the blame should reflect the substantial very likely undermine market discipline and evidence of fundamental failures in U.S. and protect even more institutions, investors, foreign regulation of commercial banking, and consumers from the downside of risky thrift lending, and investment banking. behavior. The debate over optional federal Despite AIG’s enormous exposure to chartering of insurance companies should increases in mortgage default rates, it is not likewise recognize the fundamental impor- clear that any of its insurance subsidiaries tance of avoiding expanded government guar- would have become insolvent if the govern- antees of insurers’ obligations. ment had not intervened. Most federal assistance to AIG has been paid to banking counterparties. There can be little doubt Endnotes that federal intervention was influenced by 1 See, for example, John B. Taylor, “The Finan- the desire to protect those counterparties. cial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,” National Bureau Whether AIG’s CDS portfolio and securities of Economic Research Working Paper No. w14631, lending presented significant risk of conta- November 2008; Adrian Blundell-Wignall, Paul gion has and will be debated. But the general Atkinson, and Se Hoon Lee, “The Current Finan- consensus is that systemic risk is relatively cial Crisis: Causes and Policy Issues,” OECD The primary low in insurance markets compared with Financial Market Trends, 2008; Markus Brun- objectives of banking, especially for property/casualty nermeier, “Deciphering the Liquidity and Credit legislative and insurance, in part because insurers hold Crunch 2007-08,” Journal of Economic Perspec- tives, Vol. 23, No. 1(Winter 2009); Steven Schwarcz, regulatory greater amounts of capital in relation to “Systemic Risk,” 97 Georgetown Law Journal 193, responses to the their liabilities, reducing their vulnerability (2008); and Lawrence W. White, “How Did We Get financial crisis to shocks. Creating a systemic risk regulator into This Financial Mess?” Cato Institute Briefing for insurers and other non-bank institu- Paper No. 110, November 18, 2008. Also see my should be to tions designated as systemically significant summary, “Moral Hazard and the Meltdown,” The strengthen bank would not be good policy. Any institution Wall Street Journal, May 23, 2009. capital regulation designated as systemically significant would and otherwise 2 In a June 19, 2009, speech at the American Enter- be regarded as too big to fail, reducing encourage market market discipline and giving it an inappro- prise Institute, former Federal Reserve Chairman priate competitive advantage. Nor do the Alan Greenspan commented: “As partnerships, discipline in investment banks were an exceedingly cautious AIG crisis and federal intervention funda- banking, insurance, bunch. They rarely took speculative positions, as mentally strengthen arguments for either general partners were particularly sensitive to their and other financial optional or mandatory federal regulation of personal unlimited liability. It is inconceivable institutions. insurance. that, as partnerships, investment banks would have taken the enormous risks that turned out so badly The primary objectives of legislative and this decade.” regulatory responses to the financial crisis should be to strengthen bank capital regu- 3 Compare Steven Labaton, “Agency’s ’04 Rule Let lation and otherwise encourage market Banks Pile Up New Debt,” The New York Times, discipline in banking, insurance, and other October 3, 2008, and “Remarks at the National Economists Club: Securities Markets and Regula- financial institutions as a means to promote tory Reform,” by Erik R. Sirri, Director, Division of safety and soundness. An overriding goal of Trading and Markets, U.S. Securities and Exchange any regulatory changes in response to the Commission, Washington, D.C., April 9, 2009. AIG anomaly should be to avoid extending explicit or implicit too-big-to-fail poli- 4 See Rob Schimek, “AIG and AIG Commer- cies beyond banking. The creation of a cial Insurance: Overview and Financial Update,” systemic risk regulator and expanded federal presentation (http://www.aig.com/aigweb/ authority over financially distressed insurers internet/en/files/RSSPres111308b_tcm20-132858. and other nonbank institutions would pdf) [November 13, 2008]. Through December 19, 81 percent of A.M. Best Company’s property/

29 casualty rating actions in 2008 had affirmed 14 Dinallo testimony, March 5, 2009. On the prior ratings. Four percent were downgrades; 4 other hand, prior to the federal intervention the percent were upgrades. Miscellaneous catego- NYID reportedly consented to a $20 billion loan ries accounted for the remainder. See Robert from the insurance subsidiaries to the holding Hartwig, “Financial Crisis and the P/C Insur- company, which was mooted when the Federal ance Industry – Challenges and Opportunities Reserve intervened. AIG’s securities lending and amid the Economic Storm,” presentation at the regulatory response is discussed further in testi- Latin American Association of Insurance Agen- mony by Pennsylvania Insurance Commissioner cies Convention, (http://www.iii.org/assets/docs/ Joel Ario, “Testimony of the National Association ppt/090717LatinAmericanAgents.ppt) [July of Insurance Commissioners Before the Subcom- 2009]. mittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee 5 See Leslie Scism, “Long Derided, This Invest- on Financial Services, United States House of ment Now Looks Wise,” The Wall Street Journal, Representatives, regarding: ‘American Interna- June 22, 2009, D1. tional Group’s Impact on the Global Economy: Before, During and After Federal Intervention,’” 6 The NAIC website (www.naic.org) provides full March 18, 2009. details of insurers with state exceptions to statu- tory (regulatory) accounting rules. 15 Robert Eisenbeis, “An Interesting Issue: AIG – Part One of Three,” Cumberland Advisors, March 7 Testimony to the United States Senate 18, 2009. Committee on Banking, Housing, and Urban Affairs, hearing on “American International 16 Ario testimony, March 18, 2009. Pennsylvania Group: Examining What Went Wrong, Govern- Insurance Commissioner Joel Ario testified ment Intervention, and Implications for Future strongly that AIG’s CDS problems led to the run Regulation,” by Superintendent Eric Dinallo, New on its securities lending operation and that “AIG’s York Insurance Department, March 5, 2009. insurance companies remain strong.” AIG’s prop- erty/casualty operations were subject to much 8 AIG SEC Form 10-K, 2008. Unless otherwise less stress than its life insurance and retirement noted, AIG financial data are obtained from this services and generally are regarded as reasonably source. Sometimes specific page references are strong. Its commercial property/casualty insurers provided. had a risk-based capital ratio of 452 percent at the end of the third quarter 2008, well above the 9 See, e.g., Agasha Mugasha, “The Secondary 200 percent regulatory criterion for company Market for Syndicated Loans: Loan Trading, action to improve financial strength. See Rob Credit Derivatives, and Collateralized Debt Schimek, “AIG and AIG Commercial Insurance: Obligations,” Banking & Finance Law Review, Overview and Financial Update,” November 13, (February 2004). 2008. Based on analysis of the statutory filings of AIG’s domestic insurance subsidiaries, David J. 10 The 1988 Basel Accord or “Basel I” by the Merkel argues that “some of the life and mortgage Basel Committee on Bank Supervision proposed subsidiaries would have gone into insolvency, international bank capital regulations based but the company as a whole would probably primarily on credit risk. In 1999 the committee have survived.” See his article, “To What Degree proposed more elaborate requirements (“Basel Were AIG’s Operating Insurance Subsidiaries II”), including reliance on companies’ internal Sound?, “Seeking Alpha (http://seekingalpha. models for setting required capital under certain com/article/134260-to-what-degree-were-aig-s- conditions. operating-insurance-subsidiaries-sound-part-1) [April 28, 2009]. Also see Mary Williams Walsh, 11 Dinallo testimony, March 5, 2009. Borrowers “After Rescue, New Weakness Seen at A.I.G.,” The demanded the return of $24 billion in cash from New York Times, July 31, 2009, (which mischarac- September 12 through September 20 alone. terizes the role of intra-group reinsurance in the industry) and the reply letter to the Times’ editors 12 Dinallo testimony, March 5, 2009. also dated July 31 by Kermitt Brooks, Acting New York Insurance Superintendent, and Joel Ario, 13 AIG 2008 SEC Form 10-K, p. 40. Pennsylvania Insurance Commissioner, stating:

30 “We are convinced, based on a complete, broad 27 See, for example, Dwight Jaffee, “Credit Default and deep ongoing review of all current material Swaps, Systemic Risk, and Insurance Regulation,” information, that the claims-paying abilities of presentation to the ARIA-NAIC-Symposium, U.S. these companies [AIG’s U.S. insurance subsid- Insurance Regulation: What Have We Learned, iaries] remains appropriate.” Where Do We Go?, July 13, 2009, and Charles Calomiris, “Financial Innovation, Regulation and 17 AIG 2008 SEC Form 10-K, p. 50. Reform,” The Cato Journal 29, (Winter 2009). Also see Corine Hegland, “Why the Financial System 18 AIG 2008 SEC Form 10-K, p. 167. The bulk of Collapsed,” National Journal Magazine, April 11, the $29.1 billion was for highly rated securities. 2009.

19 Not included in the table is a plan announced 28 Orice M. Williams, “Federal Financial Assis- on March 2, 2009, for AIG to repay $8.5 billion tance: Preliminary Observations on Assistance and reduce the credit line from proceeds of Provided to AIG,” U.S. Government Accountability a planned life insurance securitization. I was Office, GAO-09-490T, March 18, 2009. The Penn- unable to confirm that the repayment occurred. sylvania Department of Insurance subsequently announced that it was launching an investiga- 20 The data source, “AIG Discloses Counter- tion of AIG’s pricing. A study by Karen Epermanis parties to CDS, GIA and Securities Lending and me, “Market Discipline in Property/Casu- Transactions,” (http://www.aig.com/Home- alty Insurance: Evidence from Premium Growth Page_20_17084.html) March 15, 2009, rounds Surrounding Changes in Financial Strength each recipient’s amount to the nearest $100 Ratings,” Journal of Money, Credit and Banking 38, million. (September 2006), documents significant premium declines for commercial property/casualty insurers 21 Statement of Donald L. Kohn, Vice Chairman, that are downgraded, especially when the down- Board of Governors of the Federal Reserve grade causes their financial rating to drop below System, before the Committee on Banking, A-. Housing, and Urban Affairs, U.S. Senate, March 5, 2009. 29 AIG’s domestic property/casualty premiums for the second quarter of 2009 were 18 percent lower 22 Harvey Rosenblum, et al., “Fed Intervention: than the second quarter of 2008 (see AIG Financial Managing Moral Hazard in Financial Crises,” Supplement, Second Quarter 2009). Comparable Economic Letter – Insights from the Federal nationwide data are not yet available. Reserve Bank of Dallas, Vol. 3, No. 10 (October 2008); Robert Eisenbeis, “AIG – Part Three of 30 Some academics therefore call gradual dissemi- Three,” Cumberland Advisors, March 19, 2009. nation of the effects of a common shock “informa- tion contagion.” 23 AIG 2008 10-K, p. 297. 31 Committee on Capital Markets Regulation, The 24 AIG 2008 10-K, p. 298. Global Financial Crisis – A Plan for Regulatory Reform, May 2009, p. ES-3. 2 Kohn testimony, March 5, 2009. Federal Reserve Chairman Ben Bernanke also has referred to 32 While technically not contagion, a related AIGFP as an unregulated entity. Also see Robert problem is that shocks to some financial institu- Eisenbeis, “AIG – Part Two of Three,” Cumber- tions will directly reduce the values of securities land Advisors, March 18, 2009. they have issued, thus reducing the net worth of other financial institutions that invested in those 26 Statement of Scott M. Polakoff, Acting securities. For example, if an insurance holding Director, Office of Thrift Supervision, U.S. company invests in bonds or notes issued by a Department of Treasury, concerning Modern- bank holding company that later runs into finan- izing Bank Supervision and Regulation before cial difficulty, the associated decline in the value the Committee on Banking, Housing and Urban of the bonds and notes will reduce the insurance Affairs, U.S. Senate, March 19, 2009. holding company’s assets and net worth. Cross- purchases of securities among financial institu- tions are not uncommon.

31 33 See generally Jean Helwege, “Financial Firm Solvency Regulation,” Regulation: Cato Review of Bankruptcy and Systemic Risk,” Regulation: Business and Government 15, (Spring 1992). The Cato Review of Business and Government 32, (Summer 2009), and George Kaufman and 39 See, “Financial Regulatory Reform – A New Kenneth Scott, “What is Systemic Risk, and Do Foundation: Rebuilding Financial Supervision Bank Regulators Retard or Contribute to It?” The and Regulation,” U.S. Department of the Trea- Independent Review 7, (Winter 2003) for discus- sury, June 18, 2009. For a detailed summary and sion and citations to general evidence. commentary, see “Treasury Releases White Paper Proposing Significant Financial Services Reform,” 34 Robert Eisenbeis, “AIG – Part Three of Three,” Goodwin Proctor LLP Financial Services Alert, Vol. Cumberland Advisors, March 19, 2009; Testimony 12, June 23, 2009. of Peter J. Wallison before the House Financial Services Committee, March 17, 2009. 40 The Treasury also proposes a controversial new agency to regulate financial products, but not 35 In this regard, Peter Wallison testified before insurance products specifically. the House Financial Services Committee on July 21, 2009, as follows: “If Goldman, AIG’s largest 41 U.S. Treasury news release (http://www.ustreas. counterparty, would not have suffered significant gov/press/releases/reports/title%20v%20ofc%20 losses, there is no reason to believe that anyone natl%20ins%207222009%20fnl.pdf). else would have suffered systemically significant losses either.” 42 I made some of the arguments in my statement on “How Should the Federal Government Oversee 36 Following the bailout, AIG has argued that it is Insurance?” before the Subcommittee on Capital characterized by significant systemic risk, espe- Markets, Insurance, and Government Sponsored cially in life insurance. See AIG presentation Enterprises, Committee on Financial Services, dated March 6, 2009, “AIG: Is the Risk Systemic?” U.S. House of Representatives, May 14, 2009. Also see Peter J. Wallison, “Statement before the Senate 37 See, for example, my article, “Capital Adequacy Banking Committee On Regulating and Resolving in Insurance and Reinsurance,” in Capital Institutions Considered ‘Too Big to Fail,’” May 6, Adequacy Beyond Basel: Banking, Securities, and 2009; statement of the Shadow Financial Regula- Insurance, Hal Scott, ed., (Oxford University tory Committee on Monitoring Systemic Risk, Press, 2004), and Peter J. Wallison, “Statement Statement No. 271, May 4, 2009; and Robert before the Senate Banking Committee On Regu- Eisenbeis, “AIG – Part Three of Three.” Many lating and Resolving Institutions Considered ‘Too observers have taken issue with proposals to make Big to Fail,’” May 6, 2009. Joao Santos, “Bank the Federal Reserve the systemic risk regulator in Capital Regulation in Contemporary Banking view of possible conflicts with monetary policy Theory: A Review of the Literature,” BIS Working and an aversion to expanding the authority of an Paper No. 90, 1999, explains why systemic risk is agency whose monetary policy and deficient regu- generally lower for all non-bank financial institu- latory oversight played a major role in causing the tions than for banks. Rolf Nebel, “The Case for financial crisis. For example, see the statement of Liberal Reinsurance Regulation,” Swiss Re, 2001, Alice Rivlin before the Committee on Financial provides a useful discussion of why systemic risk Services, U. S. House of Representatives, July 21, is low for insurance. 2009. Ms. Rivlin, a Brookings Institution senior fellow, Georgetown University professor, and first 38 See, for example, George Fenn and Rebel Cole, director of the Congressional Budget Office, testi- “Announcements of Asset-Quality Problems and fied: “As regulator of bank holding companies, Contagion Effects in the Life Insurance Industry,” [the Federal Reserve] did not distinguish itself Journal of 35,1994; Elijah in the run up to the current crisis (nor did other Brewer and William Jackson, “Intra-Industry regulators). It missed the threat posed by the Contagion and the Competitive Effects of Finan- deterioration of mortgage lending standards and cial Distress Announcements: Evidence from the growth of complex derivatives.” Commercial Banks and Insurance Companies,” Federal Reserve Bank of Chicago Working Paper 43 Regarding moral hazard and lower capital costs, No. 2002-23; and my article, “Policyholder Runs, for example, R. Glenn Hubbard (Columbia Busi- Life Insurance Company Failures, and Insurance ness School Dean and former chair of the Presi-

32 dent’s Council of Economic Advisors under 47 I elaborate in great detail in Insurance Deregu- G.W. Bush), Hal Scott (Harvard Law School lation and the Public Interest, (Washington, D.C.: professor), and John Thornton (chairman of the AEI Press, January 2000). Brookings Institution) wrote in “The Fed Can Lead on Financial Supervision, The Wall Street 48 I briefly discussed these alternatives in “Federal Journal, July 24, 2009, A13: “Identifying an insti- Chartering of Insurance Companies: Options and tution as systemically important creates a moral Alternatives for Transforming Insurance Regula- hazard, since the market will view this designa- tion,” Networks Financial Institute Policy Brief, tion as the equivalent of a bailout guarantee. A 2006-PB-02, (March 2006). Also see Henry Butler perceived bailout guarantee will decrease these and Larry Ribstein, “The Single-License Solu- institution’s costs of raising capital.” tion,” Regulation: The Cato Review of Business and Government, (Winter 2008-2009). 44 In the words of Robert Eisenbeis, chief econo- mist for Cumberland Advisors, former banking 49 See, for example, Robert E. Litan, “Regulating professor, and member of the Shadow Finan- Insurance After The Crisis,” The Initiative on Busi- cial Regulatory Committee, when discussing the ness and Public Policy at Brookings, March 4, implication that lack of systemic risk authority 2009. Litan also argues that “spillovers” of mono- hindered federal response to the crisis: “What line mortgage insurers on the municipal bond would the Fed have done differently had it been market were indicative of significant systemic risk. officially designated as systemic risk authority – both in advance of and during the crisis?” “AIG – 50 “Addressing Systemic Risk: Remarks by Alan Part Three of Three,” March 19, 2009. Greenspan” (www.aei.org/speech/100052 [June 3, 2009]). 45 The general debate over state versus federal insurance regulation goes back much longer. 51 I elaborated this point in “Moral Hazard and the I’ve written extensively on these issues for nearly Meltdown,” The Wall Street Journal, May 23, 2009. two decades. See especially “Federal Chartering of Insurance Companies: Options and Alterna- 52 See, for example, Dwight Jaffee, “Credit Default tives for Transforming Insurance Regulation,” Swaps, Systemic Risk, and Insurance Regulation,” Networks Financial Institute Policy Brief, 2006- presentation to the ARIA-NAIC-Symposium, U.S. PB-02, (March 2006); “Optional Federal Char- Insurance Regulation: What Have We Learned, tering of Property-Casualty Insurance Compa- Where Do We Go?, July 13, 2009, and “The Appli- nies,” Alliance of American Insurers, (2002); cation of Monoline Insurance Principles to the “An Historical Overview of Federal Involve- Reregulation of Investment Banks and GSEs,” ment in Insurance Regulation,” Peter J. Wallison, Haas School of Business, University of California, ed., Optional Federal Chartering of Insurance Berkeley, November 10, 2008. (Washington, D.C.: American Enterprise Insti- tute, 2000); “Policyholder Runs, Life Insurance Company Failures, and Insurance Solvency Regulation,” Regulation: Cato Review of Business and Government 15 (Spring 1992); and “Should the Feds Regulate Insurance?” Regulation: Cato Review of Business and Government 14 (Spring 1991).

46 Some people advocate pre-funding of guar- antees with risk-based premiums. It is unlikely, however, that meaningful risk-based premium variation would be achieved in practice. Pre- funding would sacrifice the advantages of ex post funding without achieving enough risk rating to significantly improve incentives.

33 Notes NAMIC Issue Analysis Public Policy Papers (continued from back cover)

The Legal Theory of Disparate Impact Does Not Apply to the Regulation of Credit-Based Insurance Scoring Robert Detlefsen, Ph.D. July 2004

The Damaging Effect of Regulation of Insurance by the Courts Peter A. Bisbecos and Victor E. Schwartz August 2003

Regulation of Property/Casualty Insurance: The Road to Reform April 2002

Market Conduct Regulation for a Competitive Environment January 2001

Analysis of the Role, Function and Impact of Rating Organizations on Mutual Insurance Companies September 2000

Accepting the Challenge: Redefining State Regulation Now April 2000

Should the Community Reinvestment Act Apply to Insurance Companies? August 1999

Focus on the Future: Options for the Mutual Insurance Company January 1999 Founded in 1895, the NAMIC Issue Analysis Public Policy Papers National Association of Mutual Insurance Each year, the National Association of Mutual Insurance Companies (NAMIC) publishes Companies is the an Issue Analysis paper that examines a significant public policy issue involving risk largest, most diverse management and insurance. These monographs provide a forum for university- national insurance based insurance scholars and other independent experts to apply timely research and trade association in the sophisticated analysis to important insurance-related problems and controversies. United States. NAMIC represents the interests Issue Analysis papers reach a wide audience that includes federal and state lawmakers of its property/casualty and regulators, think tanks, trade associations, the media, and insurance professionals. insurance company Through its Issue Analysis publishing program, NAMIC seeks to elevate public discourse, members and their inform the policymaking process, and improve the functioning of insurance markets for policyholders. NAMIC’s the mutual benefit of insurers, consumers, and taxpayers. membership includes Previous Issue Analysis titles include: farm mutual insurance companies, single-state First-Party Insurance Bad Faith Liability: Law, Theory, and Economic Consequences and regional writers, Sharon Tennyson, Ph.D., and William J. Warfel, Ph.D., CPCU, CLU and national insurers September 2008 operating across North America. The more than The Assault on the McCarran-Ferguson Act and the Politics of Insurance 1,400 NAMIC members in the Post-Katrina Era underwrite 41 percent Lawrence S. Powell, Ph.D. of the automobile and August 2007 homeowners insurance Auto Insurance Reform Options: How to Change State Tort and No-Fault Laws to market and 31 percent of Reduce Premiums and Increase Consumer Choice the business insurance Peter Kinzler, J.D. market in the United August 2006 States. It’s Time to Admit that SOX Doesn’t Fit: The Case Against Applying Sarbanes-Oxley Act Governance Standards to Non-Public Insurance Companies Sophie M. Korczyk, Ph.D. June 2005

Insuring the Uninsurable: Private Insurance Markets and Government Intervention in Cases of Extreme Risk Sophie M. Korczyk, Ph.D. March 2005 Headquarters 3601 Vincennes Road The Case for Underwriting Freedom: How Competitive Risk Analysis Promotes Indianapolis, IN 46268 Fairness and Efficiency in Property/Casualty Markets (317) 875-5250 Robert Detlefsen, Ph.D. September 2004 Washington Office (continued inside) 122 C Street, N.W. Suite 540 To order any NAMIC Public Policy Paper, e-mail NAMIC Vice President of Public Policy Washington, D.C. Robert Detlefsen at [email protected], or call the NAMIC State and Policy Affairs (202) 628-1558 Department at (317) 875-5250. www.namic.org All NAMIC Public Policy Papers are available on NAMIC Online at www.namic.org.