Oral Statement of Scott E. Harrington

Alan B. Miller Professor

The Wharton School, University of Pennsylvania

On “How Should the Federal Government Oversee Insurance?”

Before the Subcommittee on

Capital Markets, Insurance, and Government Sponsored Enterprises

Committee on Financial Services

United States House of Representatives

May 14, 2009

(These remarks summarize my written testimony.)

Chairman Kanjorski, Ranking member Garrett, and members of the Subcommittee:

I am pleased for this opportunity to testify on an issue of fundamental importance to the economic security of individuals and businesses.  I have three main points, which I elaborate in my written statement.

First, insurance is fundamentally different from banking and should not be regulated the same way.  AIG notwithstanding, insurance markets are characterized by minimal systemic risk and by reasonably strong market discipline for safety and soundness.  Any new regulatory initiatives that affect insurance should be designed not to undermine that discipline.

Systemic risk – the risk that problems at one or a few institutions threaten many more institutions and the overall economy – is much greater in banking than in insurance.  Depositor and creditor runs on banks threaten the payment system.  Banking crises involve immediate and widespread harm to economic activity and employment.

Systemic risk provides some rationale for relatively broad government guarantees of bank obligations.  Because guarantees undermine market discipline, they create a need for tighter regulation and more stringent capital requirements.  This in turn creates significant pressure from many banks to relax capital requirements and improve their accuracy.

Insurance is inherently different, especially property/casualty and health insurance.  There is much less systemic risk and thus need for broad government guarantees to prevent runs that would destabilize the economy.  Guarantees have appropriately been narrower than in banking.  Capital requirements have been much less binding; their accuracy generally has been less important.  This is good economics.  Any new insurance regulatory initiatives should follow this model and continue to recognize the differences between banking and insurance, and that apparently sophisticated capital regulation may produce significant distortions without sufficiently constraining excessive risk taking.

My second main point is that creation of a systemic risk regulator with authority to regulate “systemically significant” insurance organizations would likely have several adverse consequences.  In general, the potential benefits of creating a systemic risk regulator encompassing nonbank institutions strike me as modest and highly uncertain.

Regarding insurance specifically, if an entity were created with authority to regulate any insurer it deemed systemically significant, market discipline could easily be undermined with an attendant increase in moral hazard and excessive risk taking.  An insurer designated as systemically significant would be regarded by many market participants as too big to fail.  Implicit or explicit government backing would lower its funding costs and increase its incentives to take on risk.  I am skeptical that tougher capital requirements or tighter regulation would be adopted for such firms and, if so, be effective in limiting risk taking over time.  Government / taxpayer bailouts could become more rather than less likely.

Even if moral hazard would not increase, it is hardly certain that a systemic risk regulator would effectively limit risk in a dynamic, global environment.  It could well be ineffective in preventing a future crisis, especially once memories of the current crisis fade.

In addition, level competition between insurers designated as systemically significant and those not so designated would not be possible.  The former would likely have a material competitive advantage.  The results would likely include higher market concentration, less competition, and more moral hazard.

Apart from AIG, the insurance sector has withstood the events of the past two years tolerably if not remarkably well.  Some large life insurers have been stressed – hardly surprising given sharp falls in asset values and minimum return guarantees provided on some of their products.  The AIG intervention occurred in response to a liquidity crisis resulting from banking and securities lending activities, often with banks as counterparties.  It was not due to AIG’s core insurance operations, which appear to have been fundamentally sound at the time of intervention.

The full consequences of extending “too big to fail” to AIG, in significant part to protect bank counterparties, are still uncertain.  But the appropriate lessons do not include the need for a systemic risk regulator with authority over insurance.

My third and last point is that legislative proposals for federal intervention in insurance regulation, such as optional federal chartering, should specifically seek to avoid expanding the scope of explicit or implicit government guarantees of insurers’ obligations.  That goal should be central to any debate.

Insurance markets have largely been outside the scope of too big to fail policy until AIG.  Consistent with lower systemic risk, state guarantees of insolvent insurers’ obligations are limited, reducing moral hazard and helping to preserve market discipline.  Customers, especially business buyers and brokers, generally pay close attention to insolvency risk.

Post-insolvency assessment of surviving insurers to fund state guaranty association obligations is appropriate.  Insurers can respond effectively to such assessments without pre-funding.  Potential assessments also provide incentives for financially strong insurers to press for effective regulatory oversight.

If you consider optional federal chartering and regulation of insurers, I hope you will also explore alternatives that could encourage regulatory competition among the states, or that would preempt anti-competitive state regulation.  In any event, I urge you to recognize the central importance of avoiding expanded government guarantees of insurers’ obligations.  This might be achieved under optional federal chartering by requiring federally chartered insurers to participate in state guaranty systems, by or patterning federal guarantees after state guarantees, perhaps with modifications to further enhance market discipline for safety and soundness, thus reducing the need for restrictive regulation.

Thank you.