American Enterprise Institute

July 9, 2008

[Edited transcript from audio tapes]

8:15a.m.	Registration
8:30	Introduction:	Peter J. Wallison, AEI
		Jack Sinnott, Risk Foundation Robert Klein, Georgia State University
9:00		Panel I: The Framework for Insurance Regulation
	Presenters:	Martin Grace, Georgia State University
		Hal S. Scott, Harvard University
		“Optional Federal Chartering of Insurance: Rationale and Design of a Regulatory Structure”
		Robert Detlefsen, National Association of Mutual Insurance Companies
		“Potential Consequences of Dual Insurance Chartering”
	Discussant:	Robert Inman, University of Pennsylvania
	Moderator:	Robert Klein, Georgia State University
10:40		Panel II: Insurance Regulatory Policies
	Presenters:	Martin Grace, Georgia State University
		Robert Klein, Georgia State University
		“Insurance Regulation: The Need for Policy Reform”
		Robert E. Litan, Brookings Institution
		“The Consumer Benefits of an Optional Federal Charter: The Case of Auto Insurance” (coauthored with Phil O’Connor)
	Discussant:	Dennis Carlton, University of Chicago
	Moderator:	Peter J. Wallison, AEI
		“Convergence in Financial Services Markets: Likely Effects on Insurance Regulation”
12:00p.m.	Luncheon
	Special Remarks:	David Nason, U.S. Department of the Treasury
1:30		Panel III: Insurance Regulation, Financial Convergence, and International Trade
	Presenters:	Peter J. Wallison, AEI
		“Financial Convergence and Insurance Regulation”
		John Cooke, International Financial Services London
		Harold Skipper, Georgia State University
		“An Evaluation of U.S. Insurance Regulation in a Competitive World Insurance Market”
	Discussant:	Elizabeth Brown, University of St. Thomas
	Moderator:	Robert E. Litan, Brookings Institution
3:00		Panel IV: Perspectives on Insurance Regulation
	Presenters:	Andrew Beal, National Association of Insurance Commissioners
		Cecelia Kempler, Florida Atlantic University
		Terri Vaughan, Drake University
	Moderator:	Martin Grace, Georgia State University
4:00	Adjournment

Proceedings:

Peter J. Wallison:  Good morning.  Good morning to everyone.  If you will all please take your seats, we will try to get started.  We have a full program and a full house today.  My name is Peter Wallison, and I’m a senior fellow here at the American Enterprise Institute.  And I want to welcome all of you to what will be, I think, a very exciting, interesting and informative program.  We do not often get groups like this or at least this size for conferences on insurance, but it shows the state of things in Washington that you are all as interested as you are in this subject and we are delighted to see all of you here.

Washington today is bubbling with ideas about financial regulation.  The Treasury Department itself has developed a new structure for the regulation of the financial services industry.  I’m sure we will hear a lot about that at lunch when David Nason speaks.  And bailout of Bear Stearns has brought new ideas for regulators to take better control of the securities industry.  We have seen that now in the agreement just this week between the Fed and the SEC, which has dramatic implications for the regulation of securities and investment banks in the future.  And concern about the role of speculators in the oil markets has resulted in calls for greater regulation of the commodities market, so we are at a very interesting and, I think, to me, dangerous time here in Washington as the government reaches for more authority over the financial markets.  All of these ideas had not left a lot of room in the public forum for the discussion of insurance regulation, but the size of the audience, I think, suggests that there is still some interest in that subject despite its being overshadowed for the moment by so many other problems that the government and Washington are wrestling with.

The most important idea in insurance, in my view, today, is the optional federal charter, which would for the first time allow insurance companies to apply for a federal charter and regulation by a newly established agency of the federal government.  Legislation for this purpose, as almost everyone in this room knows, has been introduced in the House and the Senate and has been endorsed by the Treasury Department, but the legislative mill has not really begun to grind yet.  We would hope that that will start in detail in 2009. 

Fittingly, however, today’s discussion begins with a paper on the optional federal charter.  One of the assumptions of the proponents of the optional federal charter is that state regulation will coexist relatively easily with federal chartering and regulation just as it does in the banking industry.  This may be true, but when we look carefully at the underlying economics of insurance regulation that is the reason for insurance regulation, we find that there are significant differences between the reasons for regulating insurance and the reasons for regulating banking.  This may mean that if an optional federal charter actually does become law, it will have far more impact on the insurance industry than federal chartering and regulation of banks has had on state-chartered banks.

Much of the impetus for the optional federal charter comes from the desire of insurers to gain additional freedom to meet their competition.  This is certainly true of the life insurance companies that compete in consumer financial services against banks and securities firms.  But it is also true in some commercial property and casualty lines where insurance companies compete with one another, and this includes competing abroad in the globalized market that is developing today as well as in consumer lines such as auto insurance in the local U.S. markets and internationally in other commercial lines.  Indeed, competitive convergence among all three principal members of the financial services industry - banks, securities firms and insurers - is likely to be one of the strongest drivers of change in insurance regulation as well as financial regulation in the future.

We are very fortunate to have with us today an extraordinary group of experts and scholars to discuss these issues.  I particularly want to thank Rich Phillips, Bob Klein and Martin Grace, all of Georgia State University, for doing the really hard work of structuring this conference and engaging the scholars who will be delivering their papers and commenting on the papers that you will hear today. 

Thanks are also due especially to Georgia State University and to the Brookings Institution for making this conference possible.  The papers that are presented today will ultimately be included in a book to be published by the Brookings Institution.  So this is the beginning, I hope, of a period in which we will attract more attention to the major issues that are still to be addressed in the regulation of insurance.

Most particularly, I want to thank the Risk Foundation for seeing the value of this conference when they were approached last year and for providing the necessary financial support for the conference.  Insurance regulation does not get as much attention from scholars as it should, and it certainly does not get enough attention in Washington.  By making this conference possible, the Risk Foundation has begun to address this deficiency, and we will be hearing from Jack Sinnott of the Risk Foundation in just a moment.

I would like to introduce now Rich Phillips.  Rich is a Wharton PhD in finance and insurance, who joined Georgia State University after getting his degree.  He is currently the Bruce A. Palmer professor of risk management and insurance at GSU, and he is chair of the Department of Risk Management and Insurance at GSU and has been since 2006.  He has been coeditor of the Journal of Risk and Insurance and a past president of the Risk Theory Society.  His research interests include the intersection of corporate finance and insurance economics - could not be more perfect for this conference.  And I would like to give Rich an opportunity to welcome all of you.  Rich.

Richard D. Phillips:  Thank you, Peter.  Good morning, everyone.  I just have a few welcoming remarks, and then we will get on to the program here. 

I am Rich Phillips, department chair at Georgia State.  On behalf of myself and Fenwick Huss, who is the dean of the business school, I would like to welcome you all to this program.  The Robinson College at Georgia State is the ninth largest business school in the country and is the largest business school in the southeast region of the U.S. 

The Department of Risk Management and Insurance inside that business school is the largest dedicated risk management academic group anywhere in North America.  And so I think, today, what you are seeing is just, frankly, a small part of who we are.  We have our professor emeritus, who is here today, Harold Skipper, and two faculty who are in the department, and that only represents about 20 percent of our overall group.  We are 23 people strong.  So this is truly a unique department, and we are excited to be here in Washington today to share with you a little bit about the way we think about this problem. 

The Department of Risk Management at Georgia State has been around for almost 60 years now, and for the majority of that time period, we have thought of ourselves as an insurance department.  Even though our name was Risk Management and Insurance, if the insurance industry needed students in a particular area, we tried to work with them to produce those students.

A few years ago, as the industry started changing, and particularly, after the Gramm-Leach-Bliley Act was passed, we started to get a little bit nervous.  We thought, “Well, if Congress can basically eliminate the walls that exist between banking and insurance and securities,” as Peter mentioned earlier, “how will we define ourselves in the future if the insurance industry goes away as we know it?”  Now, we all know that since Gramm-Leach-Bliley was passed, it has not had quite the dramatic effect on creating financial conglomerates that we all suspect that it might.  But nevertheless, that intellectual question to us of how we want to define ourselves in the future came about because of, at least in part, by the passage of that act.

Since that time, we have changed the way we view ourselves, and we have been on a hiring spree in an expansion through support from the Robinson College and from the university.  And today, we view ourselves much more as understanding both the measurement and the decision making around risk.  Insurance is a critical component of how risk gets transferred, risk gets priced, risk gets financed, but it is not the end-all, be-all.  And so there are a variety of other financial risk exposures, which fall under risk management.  There are decision making across individuals, across companies, across generations that deal with how a decision should be made when facing uncertain times, and that is the new mantra of this department. 

So I welcome you all here today so that we can talk a little bit about what the older generation at Georgia State has thought about for a long time on the insurance industry.  But I welcome you to learn more about this department as the next generation of leaders comes up in the department and we think about this problem in a slightly different way.

In closing, let me just say thank you to Ellen Thrower and to Jack Sinnott and the entire Risk Foundation board.  The RFP that went out last year from the board said that they were interested in funding two different projects with a maximum amount of money for both of those projects.  And we promptly sent in two proposals.  One that was, I think, $8,000 less than the maximum and the other one that was several times what the maximum was for this particular conference.  And I was a little bit worried about that strategy because we did not miss it by $50 - we missed it by well more than that.  I’m really very happy to say and pleased that the Risk Foundation agreed to break their own rules and to fund this project. 

I think this has truly come together the way that we had envisioned of bringing insurance scholars that have a tremendous amount of depth on the institutions of insurance and on the economics of these markets together with the set of researchers from other universities that come at this problem from a slightly different perspective - Hal Scott from Harvard, for example; Bob Inman from the University of Pennsylvania, my alma mater - who come at this from different backgrounds.  And I think the dialogue that we have today will truly help to inform policy around this issue, and maybe we can move the agenda forward in a little bit.

So with that, I would like to introduce Jack Sinnott from the Risk Foundation.  Jack had a long career at Marsh & McLennan, culminating in his appointment as CEO of Marsh & McLennan in 1999, a position that he held until 2003.  I’m sure everybody in this room knows that Marsh & McLennan is the largest international broker anywhere in the world, and so we are very pleased that Jack could be here today to represent the Risk Foundation and to say a couple of welcoming remarks.  Jack.

Jack Sinnott:  Thank you, Rich, and good morning.  As both the director and on behalf of the Risk Foundation, let me add my welcome to all of you today to discuss something that I have always felt is one of the most important issues for the insurance industry, not just for insurers but for brokers as well, and I spent all of my time on the brokerage side of the business. 

But first, just a bit about the foundation, it is relatively new and I think somewhat unique as a philanthropic resource in the field of risk management and insurance.  It is part of St. John’s University, being the School of Risk Management in Manhattan, which was formerly the College of Insurance that then merged into St. John’s in 2001 when the name was changed.  The foundation began formal operations in 2004 with two grants, both of which were given to Stanford to study the history of insurer insolvencies. 

And while the foundation is fully supported by St. John’s University and closely tied to the School of Risk Management, it operates as an independent public foundation and is governed by a separate 11-member board of directors.  Actually Dr. Ellen Thrower is here today.  She is the executive director of the School of Risk Management and, as a board member of the Risk Foundation, is actually the chair of the grants committee of the board.  So she is really the one who, from the Risk Foundation standpoint, led this particular effort.

The foundation was established with one goal in mind - to provide financial support in the form of grants for research and educational programs that focus on important issues involving insurance and risk management and that also will attract leading thinkers, scholars and experts in the field.  So we are pleased to fund today’s conference on regulation.  And although the impetus may have been the proposed optional federal charter, discussion on the form of U.S. regulation is not new. 

In my career of over 43 years in the insurance brokerage business, the topic of regulation has always been close to the surface.  I recall appearing with several other industry colleagues almost 20 years ago before the Dingle committee to discuss something that we call two-tier regulation.  It was basically a concept that says there are different consumers and the best regulator for personal lines and small commercial, perhaps, was at the state level, but once got into larger commercial lines and risk management, perhaps a federal oversight with most of the emphasis there being on solvency, was a better mousetrap. 

Unfortunately, that idea went nowhere, and as I look back now, I think we were a little bit naïve to think that we could cook up something like this without first getting all the support that one needs in this town.  And also, I do not think it was something that, if you look back 20 years ago, there was ever a chance of anything that some viewed as quite radical happening at that time.

Again, in 2001 and 2005, many colleagues within the insurance industry and I appeared before both the House and Senate committees on TRIA.  I happen to be representing the Council of Insurance Agents and Brokers, which is a strong advocate of TRIA.  Something, as you all know, did happen with that.  However, if you think back, I remember testifying in November of 2001, urging Congress that we needed something in place January 1, 2002.  And unfortunately, politics came in, got in the way a bit, and in the year 2002, I well remember not being able to adequately serve our clients in providing terrorist insurance because there was no federal backstop.  Congress cured that towards the end of 2002, and we did have TRIA in 2003, which was then extended for a longer period of time in 2006.

One final personal note, my business responsibility involved operations around the world, and in meeting with regulators outside of the United States, I urged that global insurers and brokers be allowed to practice, yes, with regulatory oversight but without the very significant barriers to entry that existed in many countries.  However, I recall, when meeting with some of those regulators, when asked about the form of regulation that I happen to feel was the best form, and more pointedly, was the U.S. form of regulation the best form for all classes of consumers, I had to say no.  I did not believe that, in all cases, regulation from 50 different points was the right way for the whole industry.  And I do remember that in meeting with those regulators in pushing at the reduction of barriers, my answer to that always, on the U.S. regulation, always put me back on my back foot with the real issue I was trying to put forward.

So in addition to my interest in the Risk Foundation, I do have a particular interest in the subject of regulation, making my participation today especially enjoyable.  I would not want to leave you, however, with the impression that I have a clue as to how to get things done here in Washington.  I will leave that to others.  I just know what I think is the right thing to do, but how to get it, I’ll leave to others.  I cannot offer much help in that regard.  So I look forward today to a very robust discussion on what I think is a very important issue.  And to get us moving in that direction, I’ll turn it back to Peter.  Peter.

Peter J. Wallison:  Our first panel will be moderated by Bob Klein, and I’ll introduce Bob.  I have to say that what he and Martin Grace did to get this conference together as an intellectual product was an extraordinary piece of work.  And I organize a few conferences here at AEI; I know how difficult it is to schedule scholars and experts to come in and talk.  And they started early; they worked hard on it.  They established the subjects that we are going to discuss today, and they found the right people to deliver the right papers and to comment on those papers. 

So they deserve quite a lot of credit for what they have done, and I, in particular, and all of the rest of us at Brookings and at AEI, at the Risk Foundation owe them all a debt of gratitude.  And between Martin, who is the coauthor of two papers, and Bob Klein, who is the author of one of those papers, I must say they have done a yeoman’s work on getting this thing done.

Now, Bob is the director of the Center for Risk Management and Insurance Research, and he is an associate professor of risk management and insurance at Georgia State University.  He is a leading expert on insurance regulation and markets and has 25 years of experience as a regulator and as an academic researcher.  He has written numerous articles, books and monographs on various topics. 

And I will just give you a sense of the topics that he has covered, which are really quite broad in this area: structure and performance of insurance markets; competition monitoring; price regulation; catastrophe insurance problems; urban insurance issues; workers’ compensation; solvency regulation; and international insurance regulation.  Now, that is a broad scope.  And so we are fortunate to have papers from him.  We are fortunate to have him moderating the first panel.  And Bob, I want to welcome you, and I hope you will all join me in giving him a warm welcome.  Thank you.

Robert W. Klein:  Thanks, Peter, for that introduction.  I guess the breadth of topics demonstrates both [indiscernible] and the fact that maybe my knowledge on some of these issues is not as deep as I would like it to be.  I also would like to wish you good morning, and if you have not felt welcome enough, welcome again.

My job in these first few minutes before the first panel is to start is just basically explain how the sessions or the conference is going to go today.  Before I do that, I also would like to thank all the organizations that have helped to bring this conference together, American Enterprise Institute, Brookings Institution - both organizations have contributed a great deal - and the Risk Foundation for providing the funding support and guidance.  And ultimately, I would like to also thank all of our participants in the conference today in terms of the time that they have spent in preparing for the conference and speaking today.

As you already know, the theme of today’s conference is the future of insurance regulation.  I will not try to elaborate more on what other people have said, but the focus here, obviously, is strongly driven by the current proposal for an optional federal charter.  And that basically touches or really addresses the issue of the framework for insurance regulation and who should regulate insurance, and the first panel that we will have today will be focusing particularly on that. 

But the conference is about more than just the framework for insurance regulation or who should regulate insurance because we have additional panels that will be discussing insurance regulatory policies, whether these are policies that are enforced by the states or policies that are enforced by the federal government or some combination of both, and that is also a very important topic.  And also, there will be a discussion about two important aspects of insurance regulation and their interaction with markets, and that has to do with international trade and financial convergence.  So we are talking about both framework policy and these implications for very important areas of financial market activity.

Now, in terms of the organization of the conference, basically, six papers will be presented, and there will be three panel sessions; there will two papers for each session.  You can see the topics in the agenda.  There will be a discussant for each panel that will discuss both papers, and then there will be an opportunity for Q&A with the audience after the discussant has given his comments, the panelists have responded and then it will be your turn to talk. 

So the first panel will deal with framework issues on optional federal charter.  The second panel will deal with policy reform in the insurance industry in areas where the authors feel that regulatory policies could be improved, whether at the state or the federal level.  That will bring us to lunch.  We are fortunate to have David Nason speaking at our lunch, and I’m sure his comments will be very informative and interesting.  Following lunch, we will have a third paper session where papers will be presented on the two topics of international trade and insurance regulation and financial convergence and insurance regulation.  And then, finally, we will have a last panel where three people coming from somewhat different places will present their perspectives on the topics and issues discussed today and any other opinions they might have.

So with that, the last thing I wanted to mention - and Peter had mentioned this as well - there will be life after the conference, at least for some of us.  These papers that are being presented today will undergo further revision and finalization and they will be published in a book by the Brookings Institution, which Marty and I will be involved with, and hopefully, you will see it in the next nine months or so if we work hard.  In the meantime, all the papers presented in this conference are available for download from the conference website.  Some of the revisions may be also available.  But that material will be available, and then the book will come out.  And hopefully, it will be a valuable reference to not only many of you but others who are interested in these topics or ultimately will be making decisions about them.  So with that, I would like to invite the participants for the first panel to come up, and we will get started.  We will let the debate begin.  Thank you.

Panel I: The Framework for Insurance Regulation

I’m going to go ahead and introduce all the members of the panel and basically explain what everybody is going to be doing with their roles here.  First of all, we are going to hear from my colleague Marty Grace at Georgia State and Hal Scott from Harvard, who are presenting a paper on the optional federal charter and the rationale and design of that type of regulatory structure.  Following him will be Robert Detlefsen from the National Association of Mutual Insurance Companies.  He is going to present a somewhat contrasting view, potentially, on the benefits and the disadvantages of an optional federal charter.  Robert Inman will be our discussant for both papers.  After Robert Inman presents his comments, we will give an opportunity to the authors to respond to those comments, and then we will open it up to question and answers.

We do not have a formal break between this session and the next session, but recognizing that some people may need to take a break, when we get into the Q&A session, do not feel ashamed or embarrassed if you need to leave the room.  That is okay.  We will let that discussion continue naturally to its natural conclusion or to the start of the next session.  And with that, I would like to let Marty and Hal to start things off.  Thank you.

Martin Grace:  Good morning, everyone.  I’m going to be starting off with in this tag team presentation with Hal Scott on the thinking of underlying the proposed optional federal charter and why it might be a good idea in the future.

Well, I’m going to start with a presumption.  Everyone understands what we are talking about today, the right of an insurer to choose an optional, federal insurer or a state insurer.  And today, we are going to be talking about some of the economic evidence in very high-level summary forum.  And this economic evidence does provide strong rationale for getting insurers some choice and then Hal will examine the current proposal and provides some discussions of some tweaks that might be needed to the current law.

Well, everyone has an understanding that insurance is a regulated industry and many people say it has effect with the public interests and therefore the government has a right to regulate on behalf of the citizens.  However, economists take this a different way.  They sort of say the government intervention is really designed to minimize the social cause of a market failure of some kind. 

And in insurance, they have identified two kinds of market failures.  The first kind of market failure is based upon information and we can think about the information as being a two-headed monster.  The first one is a moral hazard argument where the policy-holder may have a limited ability to discipline the management of an insurer.  And if you think about a life insurance company, for example, you buy life insurance policy in your 30s and you do not really think about it as long as you are paying your premiums until –- well you do not, you die and then someone else has to deal with it.

Well, along that time period, the insurer can undertake various activities which may actually reduce the value of the promise to pay in the future.  And so, it is very difficult for the regular consumer to monitor and discipline.  The government has the ability though, however, to monitor and discipline and it can do so at a lower social cost.  And that might be an argument for, for example, solvency regulation.

There is also other types of issues; one, we could call adverse selection.  Adverse selection might mean that in some respects, the consumer may know more about their risks than the insurer, or it can mean that the insurer knows more about its financial condition than the consumer, and so, government has the ability to monitor solvency from an adverse selection point of view.  And there is also a third type of informational problem which is, I guess, labeled confusion.  Insurance sometimes is thought to be a complicated product and it may be that the government can reduce the social cost of providing the product by setting up certain standards.  These standards can go to the contract form, it can go to how the contracts are marketed, and it can go to almost any part of the marketing arrangement. 

So these ideas of reducing informational problems are the heart of insurance regulations.  There is a second one, a second idea of market power, and some argue that because consumers are compelled to purchase some types of insurance, and the biggest ones are, for example, automobile insurance in every state is compulsory.  Worker’s compensation insurance is compulsory, and for most people homeowner’s insurance is compulsory because your mortgage lender requires insurance.

Now, the idea here is that because it is compulsory, the insurance industry has market power.  And the limited choices consumers have justify the states stepping in to regulate prices.  Well, there has been a lot of research on this issue which I will talk about briefly and will be discussed later on today that suggests that may be that is not really a valid argument for insurance regulation.  Some of the economic evidence that we have that state regulation is inefficient -- before I go on, the whole idea behind the economic rationale for regulation, it does not say that the federal government or the state government has a comparative advantage.  So it just says that there is a need for regulation if the government can actually reduce the social cost. 

Now, focusing on state regulation, in particular, there is a lot of research and it is documented in our paper that state regulation has serious inefficiencies.  Their cost of insolvency is quite high.  The market conduct regulation, this is where the states investigate the marketing of products as well as the training of agents.  This is also conflicting and it imposes tremendous cost on the companies in terms of compliance and then we also have the issue of price regulation. 

Price regulation was a good thing, one could talk about that and why it is a good thing, but the thing about price regulation that is insidious is that we have evidence that over the last 30 years prices in regulated states really do not differ from that in a competitive market state.  Except, the states spend so much money and the insurers spend so much time trying to regulate prices.  It is truly a social waste.

Now, going back to how should we think about federal versus state regulation?  And the idea behind this choosing the optimal regulatory jurisdiction is to put regulation in the hands of the governmental authority that can internalize both the cost and the benefits of regulation to a given population.  So if we have state regulation that means that the benefits of state regulation should stay within the state.  The consumers of that state should benefit.  And the cost of that regulation should be borne by the consumers of that state. 

We do not really see that.  Insurance is an interstate business.  In fact, in the paper there is a whole bunch of statistics.  But the one that I think you can point to as being interesting is that in the median states domestic market shares is about 14 percent.  Most of the business throughout United States comes from interstate transactions. 

We do have evidence of the regulatory externalities where consumers in other states bear the cost of regulation by a particular state.  And as I am going to talk about briefly, there is a lack of coordination and consistency across the state which is very costly. 

And just to point out a couple of things here, in the paper we do mini-case studies.  And these mini-case studies essentially look at how coordinated the NAIC is.  They are trying to argue that in many respects they are increasing their abilities to coordinate, but it does not seem to be very true.  In fact, I will give you one example.  The risk-based capital mono-law [sounds like] was enacted by 51 states and the District of Columbia.  And that was brought about by significant congressional pressure and that in form of the Dingle report.  But other ones –- think of the military sales rules which were designed to go after unscrupulous behavior directed at, younger, not members of the military, after congressional mandate that the states do something two years ago, only 18 so far have complied.  So there are other laws that have different degrees of uniformity.  But this just shows you that even if Congress says that you should do something it takes a long time for the states to comply. 

And finally, the General Accounting office has pointed out this problem of a hold out where a large state like New York or California or Florida or Texas can say we believe that our standards are higher than the rest of the country’s, and therefore, we are not going to adopt mono-law [sounds like].  Well, a big state like that imposes its compliance cost on everybody.  It is not just the people in the state of New York or Florida; everyone has to pay in terms of higher compliance cost.  So there is a strong economic rationale for limiting the ability of states to impose coordination in compliance cost on everyone else.  So I’m going to turn this over now to Hal who will talk about the tweaks.

Hal C. Scott:  All right, I’m the tweaker.  So I want to talk about two subjects.  First of all, the bulk of which involve the design of this new Federal Chartering Agency and I have divided this into what I call an external and internal design issues.  So I am going to start with the external ones. 

One big question is the independence of this agency.  How is it structured?  Is it part of the federal government or is it separate from the federal government?  So is it like the Fed or SEC independent, or is it part of the OCC?  And in terms of the independence argument, many people would say it would be better to be outside the government.  It would add to its credibility; it would be more likely the Congress might approve it.  But of course this would just further proliferate the numbers of regulatory agencies out there which we will hear at lunch may not be such a great idea.

The other thing I would point out about this is independence does not mean apolitical.  Is the SEC an apolitical entity?  I do not think so.  In fact, politics is actually built into the SEC from the way the members of the commission were chosen, three from the majority, two from the minority, with the chair being from the president not from the majority in Congress, but what I meant to say is from the existing administration.  So independence does not mean apolitical but it may have its own separate values.  If you look at the states on this issue, part of what I have discussed in this paper, what do the states do about -- they sort of have a lot of laboratories on this.  The states have generally created an independent agency from the normal state government. 

The second issue is how is this new chartering authority governed, is it by a kind of commission, again like the SCC, or the Fed, or is it by the chief official like the Office of the Control of the Currency?  And, again if you look at the states on this, they have a CEO concept with one person in charge, that person runs the agency more like the OCC.  It is interesting if you think of these two together independent chief official that when we create independent agencies, we do not create sort of CEO types.  We create commissions and committees.  But the states actually create an independent CEO-type which is something to think about. 

There is also going to be the question of who in the Congress will have jurisdiction over the activities of this new agency.  And will there be a new insurance committee in the Congress?  You know, I would say that probably should not be what we do because of the product overlap between insurance, banking, and securities.  It preferably should be in the banking committee. 

How will it be funded?  Will it be funded by appropriations?  Will it be funded by fees?  The states are highly divided on this issue and there are good arguments for both.  And we do not take the position on the paper on this.

The final thing is that this whole optional federal charter and the creation of this new agency came up before a major focus in this country on the consolidation of regulatory authority which is the subject of Nason’s talk.  And if you look at this in that context and say, let’s say were designing an overall regulatory structure, it would seem to me, clearly, insurance would be part of that structure.  What we argue for on the paper is a slimmed down version of the Paulson blue print more along the U.K. which would be one the federal regulatory authority like the FSA alongside the Federal Reserve.  Perhaps giving more power to the Federal Reserve on supervision than the U.K. gives to the bank of England. 

If you look at the debate going on in Washington particularly Bernanke’s speech of yesterday, of course, the Fed now seems to be angling to become the U.S. FSA.  And so, if that happens then maybe insurance is supervised by the Fed.  So this whole question of how is this agency going to be organized obviously has to be fit into the current bigger debate in Washington about restructuring of federal regulatory authority.

The other thing I would say about this that we did not say much in the paper but is certainly something to think about.  This is all about optional federal chartering.  What about mandatory federal chartering?  Is there any question in your mind that if Bear Stearns had been AIG that the Feds response would have been the same?  Now, that is to engineer some takeover or bail out in some way AIG.  AIG is a big trading company very heavily in credit derivatives interconnected to the financial system. 

So I think a debate is looming up on the side of optional federal chartering that affects the insurance business is whether at least some systematically important insurance companies will have to be regulated or supervised in some way by the federal government.  Currently, AIG has no legal access to the discount window - I use AIG as an example - but again they have de facto access.  And so, if you are sitting where the Fed is sitting, you are worried about supervising and regulating AIG.  So I think that will become part of this debate. 

Let me turn to you a second set of issues which I call internal design issues.  One thing that strikes me about the federal chartering discussion is that really when you dig down into it, it is a discussion about chartering lines not firms.  Now, in banking, of course, we charter banks.  We charter the firm.  We do not charter the holding company into some sense.  But in terms of the bank as a unit we charter a firm and we regulate all aspects of that firm at the federal level. 

The two legislated proposals in the blue print, as I read them, are really talking about chartering lines, not firms.  So the point is that you would be left with the situation in which a firm would have certain lines chartered federally, regulated by the federal government.  Let’s say they were commercial property insurance, or life insurance, but could have certain lines regulated by the state, auto insurance.  And it is not even clear from this legislation how much the optional federal charter could go to what line.  So would auto insurance have to be at the state level?  Only some lines could be at the federal level? 

So I think it would be better to start thinking about the subject of chartering firms not lines because the duplication that you introduce them to the system when you have overlap of the same firm being regulated for one line at the federal level and a different line at the state level creates, I think, unnecessary duplication because certain types of regulation like solvency regulation, go back to the old argument that we heard back in 25 years ago, it is best done at federal level. 

But if the auto insurance function is being regulated at the state, the state is regulating the solvency of the provider of auto insurance at the state level; while, at the federal level since we got business and property there, the federal level is regulating the provider of that in so far as they are worried about the risk of providing that service at the federal level.  So I think we should be talking about chartering firms and not lines.  I do not think that is what is generally being proposed. 

A second major issue is the protection of consumers in any creation of a new federal agency whether it is stand alone or part of something there.  I would say that this is Congressman Frank’s biggest concern when I heard him speak on this.  So, will there be adequate consumer protection by the federal government? 

And, of course, this issue of consumer protection again varies by line.  So, you might say, “Gee, for business insurance we are not very worried about consumer protection; auto insurance, we are very worried; life insurance, we are maybe not so worried because it is so standardized, etc.”  So different lines have different degrees of concern about consumer protection, which by the way, then links into the first question, which is, if you are really worried about consumer protection, you want to leave those consumer issues at the state level and you leave the lines there.

Well, again, for the reasons that I have already stated, I do not think that is what we should do.  I think what we need to do is create a very credible consumer protection potential at the federal level.  And what that means is a division of consumer protection whether it is a stand alone or a chartering agency or whether it is a part of an overall consumer protection division of the new FSA or the Federal Reserve.  There must be a very credible devotion of resources to consumer protection.  And going along with that, there must be enforcement and a very strong enforcement capability.  Without that as a key part of this proposal, I do not believe this legislation will pass.

Third, is what to do about residual risk is basically an auto insurance issue?  Most of the proposals I have seen at the legislation leaves this residual risks pool at the state level.  But, of course, again, if you think about everything being at the federal level and we actually regulated auto insurance firms at the federal level would it makes sense to leave the residual risk pools at a state level?  I do not think so.

So why not create a national residual risk pool.  Well, that might spread risk more but maybe certain people would not like that.  For instance, insurers of drivers in safer driving in states, it is not Massachusetts.  Although somebody told me, I drive in Massachusetts, so I found it incredible that somebody told me that we are actually pretty safe.  I have not seen the actual evidence on that.  But the point would be that a wider sharing pool for particular insurers and particular consumers in particular states might not be acceptable or there would be opposition to it.

Finally, there is the issue of the state guarantee funds.  Again, most of the proposals I have seen keep this at the state level saying, “Oh, this are really working pretty well.”  They have two very good features.  Number one, the fees for the guarantees or for the state insurance are charged post-assessment rather than a pre-assessment basis.  And secondly, there is low coverage so the reduced moral hazard.  As if the federal government could not replicate that system if it really wanted it to.  Of course, the federal government could have that system.  Now, whether that is a good system or a bad system, I do not know, I think we could debate.  But I do not think the fact that the state has designed a system that people think is good is an argument for keeping it at the state level when it could be at the federal level.

More importantly, I think the insurance or federal deposit insurance analogy here to the state guarantee funds.  If we look at the history of this, it teaches us that the person who is paying the bills should probably have the regulatory authority.  And in fact, if you look at the whole history of the way we dealt with the state-chartered banks; increasingly, we have put federal control of the state-chartered banks because of the exposure of the FDIC to the failure of those banks.  And I think that is probably the right thing to do.

If we adapted the current system, we would stand this on its head.  We would have federal regulation in state insurance of the failure of firms.  So, the states would guarantee the failure of the firms.  The feds would be regulating the firms.  So it seems to me that in some sense the state should not like that.  The state should not like being at risk for poor federal regulation; anymore, than the federal government should like being at risk in banking for poor state regulation.  So what I’m saying is I think that we need to combine in one place the guarantee function with the regulatory function.

I’m going to skip this because I do not have time to deal with it, but it is in my presentation.  And just to give you a summary here, what we talked about, I do not think we need to go back at these points.  So, thank you very much.

Robert W. Klein:  Bob, now you have to use your mental powers.

Robert R. Detlefsen:  You think so?  Is it next stop? 

Robert W. Klein:  Yes, that’s it.

Robert R. Detlefsen:  There we are.  Thank you.  In some respect, Professor Scott’s remarks I think are useful segue into my presentation because one of the burdens of my talk today is to suggest to you that the optional federal charter proposal -– if once you start to work through the details and if you actually got to the point where you started thinking seriously about how it would be implemented would lead you to conclude that a larger federal role for insurance regulation is needed even beyond what is contemplated in the current bill. 

Where we differ I think is in our view of how that would actually work out in terms of the kinds of policy results and regulatory outcomes that would ensue, once that very dominant federal regulatory presence was established.  I have a less benign view of the federal government’s likely approach to insurance regulation than my colleagues here.  And I think I want to qualify that statement, though, by emphasizing that my remarks today are really concerned, first and foremost, with property casualty insurance markets.  And within that universe, I’m concerned about how personal lines - auto and homeowners insurance in particular - would be affected by a move towards federal insurance regulation.  And so, I do not want my comments today to be construed as applying necessarily to, for example, the life insurance industry. 

In fact, in my paper, one of the points that I try to make is that the insurance industry in this country -– well the insurance industry, globally, is not a monolith.  The different lines of insurance function very differently.  They serve very different purposes.  And arguably, they have different concerns with respect to the way in which they are regulated.  For example, rate regulation are what I think has quite properly been characterized as price controls in insurances is of much greater concern to property casualty insurers than it is to life insurers.  And so, any reformed proposal that is put forward I think would want - at least from a property casualty insurance standpoint - to first and foremost address that.

And so, as you can no doubt infer from what I have said so far, I accept and endorse the critique of the regulatory regime that exists in many, if not most of the states, that has been advanced by my colleagues here and most of the people who have written about insurance regulation front in terms of its economic consequences and implications that it holds for efficiency and availability of insurance products in the market place.  The question that I want to ask is whether an optional federal charter will necessarily lead to better regulation.  And again, I think we all agreed, more or less, on what would constitute better regulation of property casualty insurance markets.

And so, we would want, for example, the optional federal charter proposal to lead to less rate regulation.  And if not, the complete deregulation of rates, the elimination of price controls on property casualty insurance products.  We would want to see a lessening of underwriting restriction of the sort that currently exists in many of the states, the interference that state laws and regulations imposed upon insurers with respect to their ability to use risk-based underwriting criteria to classify risk and price coverage. 

We would want to see the reduction if not the elimination of coverage mandates.  We would want to see reforms that would promote product innovation and facilitate the ability of insurers to bring these products to market more quickly.  We would want some degree of uniformity.  Although I think it is also worth pointing out, especially with regard to property insurance. 

Uniformity is a worthy goal in some respect but certain caveats are in order.  There might be something to be said for federalism’s capacity to address market peculiarities that exist in particular states and regions.  For example, exposures to things like natural catastrophes which vary greatly from state to state and region to region or different litigation environments that exist in the tort reform regimes in various states.  And we would want a reform that would facilitate the enhanced stability of insurers to compete within the financial service sector.  I think this is a point that applies more to life insurance than property casualty insurance because there is more overlapping in terms of the kinds of products that life insurers and say, banking entities and the securities industry offer. 

And then we would want reform that helps to facilitate greater international competition, the ability of foreign firms to compete for business in U.S. markets and vice versa, and some level of coordination in terms of the ability of the United States to be able to negotiate with foreign governments in terms of, you know, with respect to the conditions under which firms would be able to participate in the markets of both the U.S. and the foreign countries.

But I list these goals or these objectives of regulatory reform and what I at least would regard as an order of priority.  In other words I think from my purposes at least, from my perspective, rate regulation, underwriting restrictions, and coverage mandates are the things that tend to bring about the greatest and most unfortunate forms of distortion and inefficiency in the insurance market place.  Adverse selection, moral hazard, and some of the other maladies that we have heard referred to here are largely a function of those particular problems.

So what then is likelihood that an optional federal charter would improve the regulatory environment under which property casualty insurers operate?  Well it has been suggested and this I think is one of the primary arguments that is made on behalf of the optional federal charter is that in fact, it is optional and its optional character means that there will be a regulatory competition established between the federal government on the one hand and states on the other.

The idea of competitive federalism has been around for some time.  Usually it refers to competition between and among states with respect to the kind of tax regimes, labor laws, right to work laws, and things of this sort that states put in place in order to compete for businesses to set up shop in their states and hire workers in their states.  And the argument goes that if states have incentives to adjust their regulatory and tax regimes in ways that are conducive to business enterprise and growth, then those states will tend to attract more business and as a result, their economies will grow in accordance with that.

The optional federal charter concept is a variation on the competitive federalism idea in the sense that it would establish not competition between and among the states but rather between the federal government on the one hand and the states collectively on the other.  And in suggesting that this kind of an arrangement would indeed facilitate regulatory competition that would bring about the desired results that we spoke of earlier in terms of regulatory reform, the model that is usually held up as an example that demonstrates how this would work is the dual bank chartering system that we have had in place in this country since the 1860s. 

The suggestion is that banks are regulated at both the state level and the federal level, and they have been for over a hundred years and this has worked out very well, and that it has facilitated competition between the federal government on the one hand and the states on the other in terms of the kind of regulatory environment that they offer and that this has been good for the banking sector.

It seems to me, however, that there is reason to question the preposition that meaningful regulatory competition has existed under the dual bank chartering system.  In an influential law review article that was published about 20 years ago now by Henry Butler and Jonathan Macy, they challenged the conventional wisdom that dual bank chartering has had this competitive effect and argued that in fact what has happened and what really has been the case almost from the beginning is that the federal government has been the dominant regulator. 

And that was the intention of the federal government’s entry into bank regulation by offering what in effect was an optional federal charter for banks back in the 1860s.  It was done by the federal government in the hope that the federal government would be able to drive bank regulators out of business, that bank regulation would be supplanted by the federal government and that the states would essentially be deprived, as a practical matter, of their ability to regulate banks.  They did it by imposing a tax - the federal government did - on bank notes, which were one of the primary means of bank revenue at that time in the 19th century when states continued to persist in regulating banks and not enough banks switched their charters to federal charters. 

Congress raised the tax on bank notes and Butler and Macy suggested that the only reason that state-chartered bank were able to remain in existence is because of the advent of checking accounts.  And that eventually came to replace state-issued bank notes as the main way in which banks were able to make a profit.

And so state-chartered bank had been able to remain state-chartered, state regulation of banks has continued to exist in some form or fashion.  However, they also emphasize that the federal government’s powers of preemption mean that really anytime the states choose not to go along with a federal bank regulation that the federal government regards as important, the federal government can simply step in and pass a law that will override bank regulation and apply to all banks universally, whether they are federally-chartered or state-chartered.  We saw examples of these in the 1970s and I cite the Home Mortgage Disclosure Act and the Community Reinvestment Act as particular examples because I think there is a good chance that if we have a federal regulation, if we have a dominant federal regulator, we would very soon see variations of both of those laws applied to the insurance industry.

There is a movement underfoot right now at the National Association of Insurance Commissioners to apply the Home Mortgage Disclosure Act which requires banks to report on the ethnicity and race and income level of their borrowers and applicants for loans to the federal government.  There is a movement to apply the NAIC to now pass model laws that would apply that to insurers, and there has been talk for sometime about applying the Community Reinvestment Act to insurance as well.

Could insurers easily switch charters from state to federal and vice versa?  This, of course, is one of the things that would have to occur if there were to be meaningful regulatory competition between the federal government and the state governments.  And there is a good reason to think that the process would be very difficult, much more so than it is in the case of banking.  The changes that companies would have to make to adjust their compliance apparatus in switching from a federal charter back to state charter, 50 different states and vice versa, would be cost prohibitive for many insurers and I think would pose problems even for large insurers. 

So in all likelihood, what you would find I think under an optional federal charter is insurers being for all intents and purposes trapped in whatever regulatory regime they initially chose.  And to the extent that some insurers chose to remain in the state regulatory system, again, the federal government’s ability to preempt state regulatory authority would result ultimately in them operating under laws that were mandated or policies, rules that were mandated by the federal government.

I’m running out of time so I cannot get through the rest of my slides, but in my paper I suggest that the effect of federal regulation, assuming as I do that the federal government would become the dominant regulator, would be not a proverbial race to the bottom but rather a ratcheting up of regulation.  The kinds of regulatory pathologies that we see in many of the states would likely be replicated, I think, at the federal level because many of the same incentives and sort of ideological underpinnings of insurance regulation that has the effect of producing cross subsidies -- I refer to it in my paper as a sort of egalitarian view of insurance that sees property casualty insurance as a mechanism for redistributing wealth by redistributing risk.  I think that there is every reason to think that those forces would influence Congress and a federal regulator every bit as much as they have influenced the legislatures and insurance departments in some states.

There, in a nutshell, is the egalitarian view of insurance as expressed by Professor Kenneth Abraham in his very fine book, by the way, which is one of the best studies of insurance law and regulation that I have ever read.  It was published I think back in the 1980s, Distributing Risk is its title.  And he, in that book lays out three different ways of understanding the function of property casualty insurance.  One of them he calls the utilitarian view, another one is the libertarian view, which I suspect many people here would subscribe to.

The egalitarian view which should owe something to John Rawls’ Theory of Justice is that if an insurer has no means of controlling a risk he poses because of inherent weakness or lack of skill, it would deny him a quality of means to charge him more for insurance coverage than those with the strength he lacks.  I think that principle although certainly not embraced that literally, is what informs the thinking of many insurance regulators including members of Congress as demonstrated right now by attempts that are currently under way to, for example, enact legislation that would ban the use of credit-based insurance scoring in insurance despite its proven effectiveness at predicting risk.

So just to sum up, I was going to talk about some of the work or some of the activity of the Department Of Housing and Urban Development to sort of litigate insurers out or move them away through litigation from using risk-based underwriting criteria that were thought to be unfairly discriminatory towards racial and ethnic minorities.  I think that there would be more of that under a federal regulatory regime.  And we have an interesting case that came before the Supreme Court last term, Safeco v. Burr that involved the reporting requirements of insurers under the Fair Credit Reporting Act.  We had the Department of Justice under the Bush administration taking a position in that case that expressed some very strange views of insurance that I think would give us a clue as to what federal insurance regulation would be like.

So if we do not pursue an optional federal charter, what should we do to reform the system of the insurance regulation in ways that we think would improve the performance of property casualty insurance markets?  Well, one thing is obviously to continue reform efforts at the state level.  There have been some very significant reforms in states like Georgia, Kansas and even New York just recently that hold I think some promise and offer some encouragement. 

And then there is the primary state regulator or what is now referred to in some quarters as a single-license approach to reform at the national level and that is based more on a corporate law model of a regulation that would basically allow each insurer to pick a particular state in which to charter and that state’s laws will then apply in every other state in which it did business.  I do not have a view as to whether that would work or not or even be desirable but I think it is worth considering.

Thank you.

Robert W. Klein:  Thank you, Bob.  And Mr. Bob Inman from the Wharton School, University of Pennsylvania for some comments on the papers.

Robert P. Inman:  Thank you Bob.  There is a handout floating around.  I do not know if you have gotten it, but I can walk you through it if you do not have a copy of it. 

I am unambiguously an outsider to this exercise.  I am a public finance economist.  I know only what I know about insurances when I try to buy it.  I do know I’m happy I’m in Pennsylvania rather in New Jersey, but other than that, I come with very, very limited background as to the industry.  But the questions and issues that you are debating today I think are exceedingly interesting and of real interest to me as a public finance economist and, in particular, the issue of what economists will call federalism, an assignment of policy responsibilities to the state or national levels.

What I would like to do in my remarks is hopefully clarify and offer to you a way of thinking through the issues that you will be addressing.  I will offer some conjectures as to how I might move on this matters but I do that totally out of ignorance, so it is strictly for fun for me and maybe provocative for you.  And in the end would like to end with four questions that I, as an outsider to this debate, would want to know the answers to before making a call as to whether we go federal or remain at the state level.

The handout that you have, if you got the copy of it, if you do not I think I can walk you through it verbally.  It is a seven-step process so if you do not have it in front of you, you are going to have to do a little bit of intellectual exercise but not an impossible one, I think.  The process that I am going to describe for you is an effort to address the question that public finance economists call the assignment problem, and the question is who ought to do what in the federal system?  And the steps are really a very quick summary and I can give you one very concrete example of what motivated this.

This exercise that I am going to discuss was an outcome of a paper that my colleague, Daniel Rubinfeld and I did on matters of regulatory federalism and in the particular the role of federal antitrust laws as they confront state decisions to regulate economic activity.  And there was a case back in the ‘40s called the Raisin Case and what it was, was the state of California all the raisin growers of which there were many and obviously in a very competitive position vis-à-vis each other, decided that perhaps the best way to form a state raisin cartel since it would be prosecuted under antitrust rules were they to do it privately would be to have the state of California pass a Raisin Board Law, essentially setting prices of raisins.

Now the Supreme Court had to confront this question and confronted as an antitrust problem and here was the dilemma.  There is a strong sense of deference, and Mr. Detlefsen’s comments I think bear on this point, a strong sense of deference to states when the courts consider this kind of federal regulatory issues.  And the issue for the court was, whether there were any spillovers from this California raisin cartel?  The answer turns out to be yes, they were really quite significant; 80 percent to 90 percent of the U.S. consumption of raisins came from California.  So the rest of the country was obviously significantly impacted by this decision to create a raisin cartel. 

The court struggled with this thing, went through a bunch of calculations and computations, and ended up approving the raisin cartel.  And the question was why?  Well, they did a balancing act, an act of -- what were the implications for the country as a whole of having a cartel set raisin prices as opposed to the virtues of having states make public policy?  And this was essentially a preference in our paper that we call it preference for local participation in state and regulatory activities, as long as the implications of the regulation remain fairly localized in their consequences.

Well, the court struggled with this issue and the process of Dan and I struggling with these cases, we set out a seven-step process for sorting through regulatory activity.  And what I have done is to take Professors Grace’s and Scott’s paper and Mr. Detlefsen’s paper and run it through our seven steps.  And this is what we are going to find out, how all of this plays out.

So step number one: Was the proposed regulatory activity justifiably national in scope involving national externalities?  That is, where is the market failure and does the market failure extend beyond individual state borders?  And in this regard, the Grace and Scott paper I think do a very nice presentation of the market failures and then make, to my mind, an intellectually compelling - whether it turns out to be empirically compelling is another issue, and I’ll make a venture and a guess here - but intellectually compelling argument to that question that the answer would be yes. 

The market failures as was mentioned by Professors Grace and Scott are two forms of asymmetric information.  One, consumers do not understand the financial stability, i.e., product quality of the insurer.  There are two way to crack at that problem: provide the consumer with information, rating agencies’ or government evaluations and certification of soundness; or in fact insure the insurer.  One can do that either in a variety of private market options, require firms to bond themselves, or to have a state guarantee fund.  So I raise this as what I call the solvency issue.  I’m not quite sure that my term matches the term of art in this room, but that is sort of asymmetric information problem number one.

Asymmetric information problem number two is consumer ignorance of products and or prices.  And again, two solutions:  provide them with the information, consumer education or, and again, if it is just so complicated and a lot of work has been done by my colleagues at Wharton on how people handle risk and make decisions regarding risk suggest that they often make a bad hash of it.  We may have to regulate not just the products but the prices and the coverage required.

So market failures, here we go.  How extensive are these market failures?  Well, to my mind, anyway, depend on how extensive the market is that these consumers are participating in -- life, healthcare, property -- again, not understanding the full details.  My instincts are to think, “No, this is probably not a big deal across state lines.”  Well, that raises the question what would be an externality across state lines and here again the Grace-Scott paper I think is really quite useful and informative.  It is essentially on the regulatory side, that is, regulation of these markets, consumer products or of the guarantee fund involves decreasing cost.  If I figure out whose a good firm or a bad firm, I would figure it out once and now I can convey that information to many consumers and there is clearly a low marginal cost in that conveyance against the large fixed cost of actually figuring out the product or the information.  And therefore we have a decreasing-cost industry and these decreasing costs spread nationally.

So how big are these costs and how big are the advantages of moving this regulatory function up to the national level?  Well, you do some dividing of the numbers that Marty has got in his paper and it comes out to be regulatory cost, average cost, are about 4 bucks a person.  Well, they are bigger than marginal costs, okay, fair enough.  But, you know, marginal cost is low, average cost is falling; maybe, the thing bottoms out at the state level.  So my colleague Dan Rubinfeld and I in another context were actually trying to estimate - I gather Rich Phillips has done some work made, Marty with you, is it - on estimating these kind of regulatory activities.  I have not, unfortunately, seen that paper, it sounds really to me terrific and interesting and I will take advantage of it.  I do take advantage of one of the numbers in that paper.

Let me tell you what Dan and I did.  We estimated this average cost of regulatory activity using all state regulatory activities, so it is not just insurance.  It turns out to be the average cost of about 45 bucks a person across all the states in our sample, and it turns out that the efficient size at least as we try to estimate it, of the population for these all-state regulatory activities is about 10 million people.  So Pennsylvania, Ohio, New York, California are all fairly efficient.  Rhode Island, Massachusetts, Vermont, New Hampshire are inefficient.  They are too tiny to take full advantage of the economies of scale and the regulatory functions. 

So the question then becomes okay, how much money do we save if we can move Rhode Island from their inefficient regulatory position to the efficient 10-million-population size?  And the answer, again, there is a little calculation that I do, turns out to be about 3 bucks, okay, $3 a person in Rhode Island.  California, New York and Ohio are fairly efficient about that.

Now that is the government’s side of things.  What about compliance cost?  And this is again a point raised in the Grace, Scott paper and there, again, happily, there is some work done.  I think, again, Marty, you, the compliance cost stuff, or Rich?  And let me tell you what I did with that number.  I took their little elasticity.  I will not bore you with all the mathematical manipulations.  But it turns out that at least by my best guesses, and we can debate this and Marty might say I'm off by an order of 40, which is fine; it is about 5 bucks, okay?  So we have got a $3-savings on the state government regulatory side and then maybe a 5-buck savings on the compliance side - this is per person - it is about $8 a person.

Okay, so that is the economies of scale advantage nationally from getting rid of all these dinky little state programs and going national.  It is not anything to sneeze at but it is maybe not anything to get really worked up about.  So I could be wrong on the numbers, but for me, I'm willing to keep going with the conversation.  So let’s say yes, yes to the question that we found some significant externalities.

We are going to do a leap over to what I call step 4, but I do not want to miss step 2.  Suppose the answer to that question had been no; we did not see any regulatory national advantages to in terms of either externalities of this kind of economies of scale and regulation.  Step 2: Is the proposed national regulatory activity here, optional federal chartering, a correction for widespread failure of states to do deals with each other when there are advantageous agreements between the states.  Well, any IC [sounds like] may facilitate that.

One might worry, too, as an outsider I only say this to be provocative, perhaps.  Maybe they are price-fixing, who knows, okay?  There could be antitrust remedies for that.  But maybe they are facilitating the kind of interstate agreements.  More interestingly to me are within-state screw-ups in terms of regulation and I think this is probably the thing that is on most of your minds.  In particular the regulation of insurance activities within state - again, extracting what I can from the Grace-Scott summary which is very useful, I recommend it - is that there are a lot of inefficiencies lurking around in here, not just the regulatory inefficiencies of being a tiny state, but the implications of it. 

In particular, there is direct taxation of the profits of the firm.  Well, unless you are taxing excess profits, this is going to be inefficient.  There is regulated-risk pooling as Bob had mentioned as a transfer from low-risk to high-risk consumers.  This is a tax on low-risk consumers and it is inefficient to do it.  Low-risk consumers may leave coverage or buy less coverage.  It creates an inefficient risk pool.

Rate regulation, it is a potential subsidy to high-risk consumer.  Again, it is an inefficient way of trying to benefit folks who are in risky situations and there is this thing which I do not understand but I find it absolutely intriguing, called an exit tax.  I gather if you try and leave the state they can whack you with a chunk of change, right?  Well, it could be a lump sum chunk of change and from an economist’s point of view, no big deal, right?  But it could also be something that discourages firms form entering in, knowing that you are going to violate the original contract and stick them with an exit tax.  So you are going to have some pretty adverse implications.  So the bottom line when I look at all of this is to say, boy, I suspect we are right to find this a fulltime activity as a political economist and as a public finance economist, really juicy territory for empirical work and in trying to extract some policy reforms.

Well, fair enough, it is a state mess-up; maybe, it is the problem of the state and I should not worry about that at the national level.  If New Jersey does it badly, it is the problem of the folks in New Jersey.  Why should I in Pennsylvania other than to laugh at my poor friends who are commuting here from New Jersey, why should I care particularly about their inefficiencies and inability to manage their own state politics? 

Well, I would care if there were spillovers from these state inefficiencies, specialty risks, and the fact that the state of New Jersey is so inefficient, let’s say, in the management of their insurance markets, it leads economic activity not to locate in the state of New Jersey when it would be economically efficient for the firm or the households to be there.  What have I done?  I have created inefficiency within the state that now has implications for overall aggregate efficiency in the economy as a whole.  So again, nationally, I would get interested in this.

The answer to that latter question is if a firm or household cannot locate in New Jersey, can they find an equally attractive place to locate to do business or to live?  If the answer to that question is, yes; then, I do not give a hoot about New Jersey.  It is their own darned problem.  They are going to lose property values, their wages are going to be higher as compensation, and their firms will be less efficient.  But if New Jersey wants to make a mess of their regulatory environment, that is New Jerseyans’ problem, okay?

So that is the question.  Well, if the answer to that is yes, kick in to Step 4.  If the answer to that question is no, we have gone down this tree, suppose you do not find the regulatory consequences and inefficiencies all that troubling, and you do not find these within-state problems worthy of worry by folks outside of the state, then from a public finance point of view, you just say state regulation and that is the end of it.  If they do a bad job, it is their own darn business.

But if you find these implications are important, you move to Step 4.  Is the proposed regulatory activity, in this case, the optional federal charter - perhaps following some institutional reform - efficiently provided at the national level?  So we have a problem at the state, is the national level the right place to do this?  We will save on regulatory costs.  That is good.  We will introduce potentially - though, Bob’s concerns are I think worthy of consideration - a regulatory competitor for the states.  That is good.  So that will push us all into what I call Step 7.

There is the additional benefit that I gather that some of the papers will be talking about is that with banks and financial institutions, other financial institutions being regulated at the federal level we can get a common regulatory environment to think about insurance firms.  But Mr. Detlefsen quite bluntly says, “Be careful what you wish for.” 

He has got two concerns.  The federal charter will become a monopoly charter.  And the second concern is the federal charter will stress egalitarian interest at the expense of efficient provision of insurance services.  I think John Rawls would be enormously flattered to know that his perspective as to equality is somehow pervasive in Congress and I could not resist.  I looked in my copy of The Theory of Justice and health insurance is not mentioned, life insurance is not mentioned, property and casualty insurance are not mentioned either.  So I think John Rawls might want to disown his connection from the Theory of Justice to the argument. 

But nonetheless, I found the second argument that Bob mentioned really very, very important argument, namely Wilsonian politics, the idea that I’ll scratch your back if you scratch mine.  So you have a lot of high-risk folks who get together with farmers and other folks who want a handout.  And they do a deal.  And they do the deal and the deal is, yes, I'm a high-risk guy, give me coverage at low rates.  So the politics of this I think are really fairly persuasive [sounds like].

There is an additional concern but I will not go into the details of it, but is a federal bailout more likely than a state bailout?  That is, are the moral hazard problems associated with firm performance on the financial side going to be worse if we go to the federal route than if we stay at the state route?  I have done some work on this with regard to state bailouts and it is not a trivial problem.  The Brazilian financial crisis was largely driven by bailouts by the federal government of state muck-ups in their banking system.

Okay, so we now kick in -- the Grace-Scott paper offers a variety of ways of managing this OFC environment and I just simply defer to Professor Scott’s wisdom on this matters.  I think these are really important issues and have to be dealt with.  The main thing is you keep the eye on the ball of having efficient regulation when you move to the federal level.  The proposals that Professor Scott was making in their paper are all designed in that direction.

Mr. Detlefsen says do not count on it.  He basically says if you have got a bunch of Congress -- basically, Congress runs the setup, the hypothesis.  Everybody in Congress is primarily interested in making insurance available and affordable, and it is a done deal.  Now, you create all the barriers that Mr. Scott would like to create, the world is going to overcome them and this system will be inefficient.  If a consequence happens in that direction, go state regulation, do not go fed.

The last question, and in many ways to me as a public finance guy, the most interesting is here I am at Step 7.  Let’s suppose that all the evidence is pointing in the direction I can set up the safeguards, the evidence that Professor Grace presents is compelling and I'm sitting here looking at a federal policy.  Do not let it exist in a vacuum.  The state system is a mess, but that does not mean you cannot do something to reform the state system.  So is there an alternative at the state level that can stand up to the competitive and institutional advantages of the OFC alternative?

Again, being new to this whole exercise, I found the proposal by Professors Butler and Ribstein for competitive federalism which Mr. Detlefsen mentioned really very, very interesting.  The incorporation model - not the banking model - but the incorporation model stands as the alternative there and I think the proposal is well-worthy of deep analysis.  Maybe it has been done, but I think it stands as serious competitor to the OFC alternative.  I think the existing, say, system were I to jump into this as a serious exercise would depress the heck out of me, but the OFC alternative, I believe, has probably gotten fairly careful analysis.  I would hope that the alternative of competitive federalism would be worthy of equally deep thinking.

Thank you.

Robert W. Klein:  Thank you, Bob.  In the interest of time, I’ll give each of the presenters one and a half minutes to offer any response that they want to Dr. Inman’s comments, and then I want to open it up to the audience.

Hal C. Scott:  Well, I think we are dealing with the lesser of evil problems here, so there is not going to be any perfect solution.  The question you have to ask yourself is [audio glitch] optional federal charter system is better than what we have today?  Or what would be practical?  I do not think the Butler-Ribstein proposal is practical.  We can discuss that at another time.  But if we are looking at what is on the table today, I think you pointed out a lot of problems with I think optional federal chartering, but the question is would it be a better system than what we have today?

Secondly, I think that you make a very interesting point, which is worth thinking about, as to whether this competitive model in banking actually exists.  I sort of agree that it has been eroded over time to a great deal and you know, you make a very good point that the optionality in the banking world, since your basically looking at one state versus the federal government, in the insurance you are looking at 50 states versus the federal government switching costs are quite different.  Okay, so maybe we should think about, if we really wanted to do this right, reducing those costs.  I'm not exactly sure how we should do that.  Maybe it would be taking some Butler-Ribstein proposal and putting it alongside of the optional federal charter.  So if you went back to a state, you would only go to one state.  You would not have to go to 50.  In that system you would have, I think, more active competition.

Third, I think your problems about bad federal regulation, because I think there is a definite concern, would be reduced by a U.S. FSA where the insurance regulatory function was entrusted to a financial regulator who had a much broader perspective than the just maybe parochial concerns, it would motivate people to ask [sounds like] for bad kinds of regulation where they could in effect capture the insurance function.  They are trying to capture something in an FSA, it is a larger problem for you because that agency is regulating across different functions, not just insurance.  It is a different proposition.

And finally, I think the premise of -- I think your argument is reform is easier or maybe easier at the state level than the federal level.  I'm not sure that is true.  You know, why is everybody -- people are voting with their fear.  Why are the insurance companies asking for optional federal charter?  I think it is because of a long frustration with getting reform at the state level.  So, I would make those [cross-talking] --

Martin Grace:  I’ll just take thirty seconds.

I really like your seven-step program.  I think everyone should enroll in it today because even if you have difficulty with this number or that number, the analysis is really the one that I think is the way we have to think about this.  And I sort of want to also say to Bob I actually think if Rawls thought about private market insurance and Congress or state legislation, he might actually have put those in his book.  But he was looking at something a little bit different.  But I sort of want to stick up for you on that one.

Robert W. Klein:  Bob?  You have about a minute or so.

Robert R. Detlefsen:  This is very brief.  Let me just respond to something Professor Scott said, that last point you made, why are we insurers asking for this?  The answer - not all of them are.  In fact, if you looked at companies in their totality and you just, you know went in terms of absolute numbers, I suspect that a majority of companies do not favor the optional federal charter.

Hal C. Scott:  I said large companies.

Robert R. Detlefsen:  Yes.  And your second question was of those companies that do favor it, why do they favor it despite all of the things that I have said?  Well, I would perhaps modestly suggest that they have not thought it through as well as they should. 

The business of Rawls’ and the egalitarian approach to insurance regulation, of course Rawls did not mention insurance regulation in his treatise but that book was largely regarded when it was published as a theoretical justification for the modern welfare state.  And in my paper, I say, of course, you know, individual state legislators and regulators are not thinking in terms of egalitarian theory or anything like that when they do the kinds of things they do with respect to insurance regulation.

But I did want to give them some credit, really for being less than or something other than totally cynical and politically opportunistic.  Yes, the Wilsonian theory about distributed costs and concentrated benefits explains a lot of it but I think operating in tandem with that is some kind of intellectual furniture that provides a rationale for these sort of politically self-interested policies that politicians and regulators often pursue. 

People have a tremendous capacity for self-rationalization and they look for ideas or principles that they think will justify their actions and make them look less nakedly political.  And so that is why I emphasized the egalitarian view as explaining a lot of what I think goes on in modern insurance regulation.

Robert W. Klein:  Thank you very much, Bob, and the rest of the panelists.  We have just a little bit of time I think for Q&A, Peter, maybe no more than five minutes because we need the next panel to set up, so, over here, yes?

Bob Wager [phonetic]:  Bob Wager with Prudential Financial.  Since we are in Washington, let’s talk about the politics of the optional federal charter and about how we can move forward.  As I understand it, Senator Dodd’s position is he will not move forward so long as the property and casualty guys are involved.  And Mr. Detlefsen, if the optional federal charter does not work so well for the property and casualty guys, why do they not just go to Senator Dodd and say drop us out and then let the optional federal charter discussion go on for the life insurance guys?  Why would they not do that?

Robert R. Detlefsen:  I really cannot speak for those property casualty insurers who insist that in the current political environment, especially, that this is something that they want to continue to advocate.  I would think that at some point it may dawn on some people that you know, excluding property casualty from the optional federal charter and perhaps having a version of the proposal that would apply only to the life industry would make sense and that might be the direction that you see this is move in the future.

Robert W. Klein:  More questions?  Comments?  Kevin Cronin [phonetic], you have a microphone coming at you there.

Kevin Cronin:  Thank you.  I'm wondering if any of the panelists factored in, in looking at the optional federal charter proposals, the exemption for health line.  From the proposal it seems to me that this will make [inaudible] chartering company versus charter or as the question that was just asked [inaudible].  My understanding of the proposals [inaudible] health insurance as a line [inaudible].

Martin Grace:  Well, we basically did not look at health insurance and yesterday in conversations we made a point of saying, well, health insurance is different and it is different because of significant concerns about local federalism issues the states have set up essentially their own minimum benefit plans for health insurance and that is thought to be such a state prerogative.  I think that is the reason why it was left out.  Does anyone else know more about that?  But I think that is really the rationale behind it not being included.  But even so, it is still insurance and current life insurers often sell health insurance and they will have to sort of re-arrange their organization to comply if they decide to become a federally-chartered company.

Male Voice:  If I may, just to follow up, in terms of looking at the costs of the insurance, did you not look at health in terms of costs incurred to the health insurance industry [audio glitch] of mandated benefits or in connection with risk [sounds like] tools that exist in what in dozen or more states.

Martin Grace:  We did not look at particular lines of business, you know, it was kind of a global approach to this.  But what you are pointing out, though, is that there are potentially significant compliance costs with the life insurer with a significant health business splitting it off.

Hal C. Scott:  I think basically the problem that you are pointing to, I tried to get up lines versus firms.  The extent that you are having the same firm regulated by the federal government on some lines and the state on other lines where regulation or the supervision has to do with the firm, because you are worried about the solvency of the firm providing X line at the federal government, or the solvency of the firm providing Y line at the state, there is a duplicate of -- and part of the cost savings that we could achieve through having one federal agency take care of solvency, for example, will be lost.  And this is not just health to the extent that auto insurance and all these other lines -- the more lines that are left at the state, the less savings we will get, I think through the optional federal charter.

Robert W. Klein:  One last question, thirty seconds for the question and thirty seconds for the response.

Debra H. Hall:  I say it is more of a comment, Bob.  I’m Debra Hall with Swiss Re. 

First off, I would like to just say that I do not want to forget about reinsurance in this process.  I do not think I have heard the term mentioned yet in the first session.  Secondly, something that we have favored for the last couple of years now at Swiss Re is something that Professor Scott hit on and that is a meaningful choice.  We do not believe that in flipping charters as was mentioned that once you have gone to a federal charter, that flipping back to 50 states is a meaningful choice.

I had the privilege of working with Roger Ferguson as our chairman for a couple of years and that is something that Roger developed, this sense of meaningful choice.  And so we think that it is very important to have an optional federal charter that gives you an option between a federal regulator and a single-state regulator which means continuing to work with the states toward that goal, which is something I think is important.

Robert W. Klein:  I think the consensus here is that that sounds like a good comment and a good way to end this session and get ready for the next one.  So thank you very much and thank you, all the panelists.

Panel II: Insurance Regulatory Policies

Peter J. Wallison:  Okay, if everyone could please take his place.  We really are a little short of time.  These are very extensive papers and very extensive comments so I’m sorry to pull you back from your break so quickly but I would like to get on to this next panel.

We have first a paper by Martin Grace and Bob Klein called, (Insurance Regulation: The Need for Policy Reform).  I ought to mention to all of you that all of these papers are reproduced outside on a couple of tables.  Unfortunately, we did not have Mr. Inman’s material in time to reproduce it and distribute it to everyone.  If we can get a final copy of it in electronic form, we will post it on the website as soon as we can so you will be able to get the Seven Steps at that time.

But right now, we have two excellent papers to review in