The Role of Governments in the Insurance Industry

Royal Institute for International Affairs

London, U.K.2 December 2002

Robert P. Hartwig, Ph.D., CPCU, Senior Vice President & Chief EconomistInsurance Information Institute 110 William Street New York, NY 10038Tel: (212) 346-5520 Fax: (212) 732-1916 bobh@iii.org www.iii.org

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Presentation Outline

Changing Role of Government in Insurance

• Historical/Traditional Role of Government

• Is Role of Government Expanding/Contracting?

• Role & Rule of Government Beyond Direct Regulation

• Is ‘Insurance Regulation’ Obsolete or Marginalized?

• Summary & Conclusions

• Q & A

HISTORICAL ROLE OF GOVERNMENT IN

INSURANCE

Fundamentals of Insurance Regulation

Expanded View ofInsurance Regulation

Solvency

Rate/Form

ConsumerProtection

Traditional

PublicPolicy

PoliticalAgenda

Political

Pools

GuaranteeFunds

(Re)insurer ofLast Resort

Ancillary

Mitigation/Safety

Taxes/Fees &Assessments

Stimulative

Fiscal

IncomeRedistribution

Source: Insurance Information Institute

Rationale for Insurance Regulation

Why Should Insurance be Regulated?

• Contrary to public belief, there is no “right” to insurance

Therefore need justification for existence of regulation

• Frequently cited reasons are market imperfections (e.g.,

ruinous competition), consumer protection (licensing),

systematic risks (e.g., investment risk)

• Regulation has probably extended well-beyond these bounds

in some jurisdictions

IS ROLE OF GOVERNMENT IN

INSURANCE EXPANDING OR CONTRACTING?

Evidence of Expansion

Evidence of Contraction

Expansionary Influence of Government on Insurance

Government Expansion & Defense of the Status Quo

• Terrorism

• Health Care

• Social Insurance (Elderly, Disabled, etc.)

• Recent Institution of Strict Regulation (e.g., Texas?)

• Defense of Local Control over Federal Regulation

US: State vs. Federal Regulation Debate

EU: Member states slow to adopt regulations/harmonize

Governments InsuringTerror Risk

Government Backed Terrorism Insurance ProgramsTerrorism Risk Insurance

Country Provider Details

United Kingdom Pool Re Created in 1990’s due to IRA terrorism losses.

Spain Consorcio Covers “Extraordinary Risks” such as Earthquake, Volcanic Eruption, Flood, Storm, Terrorism and Civil Commotion

South Africa SASRIA Created in 1929 due to political climate in South Africa - still in existence today.

Israel PTCF Covers losses triggered by politically motivated violence (including terrorism).

France GAREAT Created post September 11, pool with state guarantee for terrorism coverage.

Germany Extremos Created post September 11, pool with state guarantee for terrorism coverage

Australia XXX Proposed in November 2002

Source: Swiss Re Focus Report: Terrorism

Industry Losses Under Proposed Federal Backstop Using 9/11 Scenario

(as proposed/interpreted from Act signed Nov. 26, 2002)

$8.75$12.50

$18.75$1.125

$10.

575

$15.

75

$18.

00

$0

$5

$10

$15

$20

$25

$30

Year 1 Year 2 Year 3

($ B

illi

ons)

Industry Retention Surcharge Layer Co-Reinsurance Layer

Source: Insurance Information Institute.

$1.75B Industry Co-Share

Assumes $30B Commercial Prop & WC Loss, $125B “At Risk” Commercial DPW

$2.0B Industry Co-Share

$0.925B Industry Co-Share

$0.125B Industry Co-Share

Total Ind. Loss: $10.875B $14.25B $19.675B

US Health Care Expenditures by Source (2000)

Medicaid16%

Out-of-Pocket15%

Private Health Ins34%

Other Govt.12%

Medicare17%

Other Private6%

Source: U.S. Dept. of Health and Human Services, Health Care Financing Administration, III.

US health care expenditures totaled $1.3

trillion in 2000. Nearly half (45%) of

expenditures are from govt.

sources

US Health Care Expenditures as a % of GDP

$2

46

$4

27 $6

96

$7

62

$8

27

$8

88

$9

37

$9

90

$1

,04

0

$1

,09

1

$1

,15

0

$1

,21

6

$1

,30

0

$1

,42

9

$1

,60

1

$4

1 $1

30

$7

3

$0

$300

$600

$900

$1,200

$1,500

$1,800

65 70 75 80 85 90 91 92 93 94 95 96 97 98 99 00 01 02*

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%Health Care Expenditures HC Exp. as % GDP

Exp

end

itures as a %

of GD

PE

xpen

dit

ure

s ($

Bill

ion

s)

Source: Bureau of Economic Analysis, Insurance Information Institute.

Government Share of Health Care Costs is Increasing

$10.

2

$27.

6

$55.

0

$104

.8

$174

.6

$282

.5

$456

.2

$587

.2

$749

.0

$30.

8

$45.

4

$74.

8

$140

.9

$252

.2

$413

.5

$534

.1

$712

.3

$852

.0

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

65 70 75 80 85 90 95 00 02*

Public Funds Private Funds*

Source: Bureau of Economic Analysis, Insurance Information Institute.

Govt. share= 46.8%Govt. share= 24.9%

37.8

%

42.4

%

42.7

%

42.5

%

41.8

%

41.7

%

41.2

%

40.9

%

41.6

%

41.9

%

40.6

%

40.4

%

40.6

%

42.1

%

43.4

%

44.0

% 45.6

%

46.1

%

46.3

%

46.0

%

45.3

%

45.2

%

45.2

% 46.8

%

24.9

%

20%

25%

30%

35%

40%

45%

50%

65 75 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02

Government’s share of health expenditures has nearly doubled from 24.9% in 1965

to 46.8% in 2003 (est.)

US Public Health Expenditures as Percentage of Total

Source: U.S. Dept. of Health and Human Services, Health Care Financing Administration, III.

4.32

%

4.27

%

4.25

%

4.25

%

4.25

%

4.29

%

4.34

%

4.41

%

4.48

% 4.90

%

5.59

%

6.23

% 6.64

%

6.78

%

6.72

%

6.66

%

6.65

%

4.46

%

2%

4%

6%

8%

2002 03 04 05 06 07 08 09 10 11 15 20 25 30 35 40 45 2050

Source: Social Security Administration

Government outlays for social security as a % of GDP will

increase by 52% by 2035

US Old-Age, Survivors & Disability Insurance Expenditures as % GDP

(“Social Security” Program)

Bush plan to “privatize” social security on indefinite hold. Time is “not ripe.”

The Texas Takeover & Maryland Maneuver

Dramatic Examples of Expansion of State Control• Texas: Dysfunctional homeowners insurance market

3.5 million HO policyholdersHistorically most expensive state to insure home (severe

windstorm, hail, tornado threat; high freq. of water claims)95% homes insured via “county mutuals”: not rate regulated ‘Toxic’ mold problems crisis of availability/affordabilityBecame major issue in campaign for governorProposals to ban county mutual/implement rate regulation

• MarylandState forced struggling insurer to provide terror coverage on

state property

Contractionary Influence of Government on Insurance

Govt. Contraction/Liberalization/Harmonization

• EU Directives

• Japanese “Big Bang” (1996)

• Harmonization efforts in US after Gramm-Leach-Bliley

• Opening of Chinese market (esp. post-WTO)

• Support of ART (generally), esp. captives

Strong interest in some states in domestic captives (e.g., Vermont)

ROLE/RULE OF GOVERNMENT BEYOND DIRECT REGULATION

Monetary/Fiscal PolicyRegulation of Securities IndustryJudicial SystemTaxationTrade PolicyNational Security & Defense

$0

$9

$18

$27

$36

$45

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02

U.S. Net Investment Income

Facts

1997 Peak = $41.5B

2000= $40.7B

2001 = $37.7B

2002E = $35.8B

Source: A.M. Best, Insurance Information Institute

Bil

lion

s

(US

$)

Investment income is directly affected by monetary policy policy, but insurance regulators are powerless to affect.

0%

2%

4%

6%

8%

10%

12%

14%

16%

3-Month T-Bill 1-Yr. T-Bill 10-Year T-Note

U.S. Interest Rates: Lower Than They’ve Been in Decades

*Average for week ending November 1, 2002.Source: Board of Governors, Federal Reserve System; Insurance Information Institute

1. Historically low interest rates are the primary driver behind lower investment yields. There is little insurers can do about this.

2. 66% of the industry’s invested assets are in bonds

Falling Interest Rates Mean Lower Bond Yields for Years to Come

3-Month Yields

3.06%

4.44%

3.65% 3.65% 3.65%

0.10%0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Canada Japan U.K. Germany France Euroland

Most Recent 2002Year Ago

Source: Blue Chip Economic Indicators, October 2002.

Interest rates are down globally. More room to fall in Europe than

in US or Japan

Insurance Industry Stock and Bond Holdings, 2001

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

CorporateBonds

CorporateStocks

State/LocalBonds

U.S. Gov'tBonds

Life P/C

In B

illi

ons

Total $1531

Total $1120

Total $209

Total $438

Source: Federal Reserve Flow of Funds Report as of Dec. 31, 2001.

P/C $194Life $1,337

P/C $185Life $935

P/C $188Life $21

P/C $131Life $307

Total Industry Holdings = $3.3 Trillion

U.S. Federal Budget Deficit/SurplusFY1990-2010*

-222

-290 -2

55

-203 -1

64

-108

-22

69

126

236

127

-157 -145 -1

11

-39

15

52

88

133 17

7

-269

-350

-300

-250

-200

-150

-100

-50

0

50

100

150

200

250

90 91 92 93 95 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

-5.0%

-4.5%

-4.0%

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%Deficit/Surplus % GDP

*FY1990-2001 actual values; FY2002-2010 are CBO forecasts.Source: Congressional Budget Office, Insurance Information Institute.

% G

DP

Em

plo

ymen

t (M

illio

ns)

Budgetary policy affects insurers directly, but insurer/ins. regulators have no influence.

Economic Outlook for Major Economies (Real GDP Growth, %)

1.5

-0.3

2.2 3.

0

1.5

7.3

1.5

3.0

1.8

1.6

5.9

0.9

3.3

7.5

1.1

3.4 4.

0

0.9

2.7

5.5

2.2

3.8

7.3

2.6

-0.2

-1.9-0.7

-2

0

2

4

6

8

Rea

l GD

P G

row

th (

%)

2001 2002E 2003F

Source: Blue Chip Economic Indicators, October 2002.

Economic outlook for 2003 is mixed/weakening for major economies,

esp. US, W. Europe, Japan

4.4%3.5%

2.5%

5.7%

8.3%

4.8%5.6%

2.2%

1.0%

-0.6%

-1.6%

-0.3%

5.0%

1.1%

2.4%3.0%2.7%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

U.S. Real GDP Growth

Source: US Department of Commerce, Blue Economic Indicators 10/02, Insurance Information Institute.

Fiscal & Monetary policy have direct impact on pace of

economic activity.

(first recession since 1990/91)

The Tragedy of Corporate Governance: Insurers Held Hostage

•Enron was tip of an iceberg

•Major implications for insurers (p/c and life)

Corporate Governance: Expensive and Hard-Learned Lessons

• Crisis of Confidence—skepticism is on the rise Ratings agencies Analysts Regulators

Investors/Creditors Employees Lawmakers

• Regulatory/Legislative Fallout Unclear SEC is “rudderless”

Enormous number of investigations under way

SEC, State Attorneys General, IRS, DoJ, etc.

Most new SEC cases are against large companies

Many competing reforms from Congress, SEC, A.G.’s., NYSE, NASDAQ, etc.

Collectively are likely to help, at least somewhat

• SEC, Administration & Congressional proposals vary

• Surge in shareholder suits well underway

Financial Restatements Filed

116

160

215233

270

0

50

100

150

200

250

300

1997 1998* 1999* 2000 2001

*ApproximateSources: Huron Consulting Group

The number of financial restatements is rising

even thought the number of publicly traded

companies is falling.

Serious Implications for Insurers

• Insurers exposed to a wide variety of risks: Investment risk (as institutional investors)

Insurance risk (surety, D&O, E&O, etc.)

Litigation risk (as both plaintiff & defendant)

Accounting Risk

Regulatory risk

• Outcome of corporate governance issue hinges most critically on

regulatory reform and enforcement in the securities industry: Insurers have little, if any, say in this debate

Enron-Related Losses for Insurers

Source: Loss estimates from Morgan Stanley as Feb. 8, 2002; Insurance Information Institute.

Surety26%

Multiple7%

D&O1%

Fin. Guarantee

2%Investment

64%

Total Exposure (Life & Non-Life): $3.796 BillionEnron is the biggest bankruptcy in US history ($31B+)

Equity/debt widely-held as S&P 500 company

Biggest impact in institutional investors/creditors

11 Congressional investigations

56 suits against officers & directors

Will spark similar suits

Average U.S. Jury Awards1994 vs. 2000

419759

187 333

1,140 1,185

1,744

1,168

1,727

269698

3,482 3,566

6,817

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

Overall BusinessNegligence

VehicularLiability*

PremisesLiability

MedicalMalpractice

WrongfulDeath

ProductsLiability

($00

0)

1994 2000

Source: Jury Verdict Research; Insurance Information Institute.

Cost of U.S. Tort System($ Billions)

Source: Tillinghast-Towers Perrin; Insurance Information Institute estimates for 2001/2002 assume tort costs equal to 2% of GDP. 2005 forecasts from Tillinghast.

$129 $130$141 $144 $148

$159 $156 $156$167 $169 $179

$198 $204

$298

$0

$50

$100

$150

$200

$250

$300

$350

90 91 92 93 94 95 96 97 98 99 00 01* 02E* 05F

Tort costs consumed 2.0% of GDP annually on average since 1990, expected to rise to 2.4% of GDP by 2005!

Tort costs equaled $636 per person in 2000!

Expected to rise to $1,000 by 2005

Who Will Pay for the US Asbestos Mess?

Source: Tillinghast-Towers Perrin; Insurance Information Institute

US Insurers30%Asbestos

Defendants39%

Foreign Insurers

31%

Estimated Total US Settlements & Expenses = $200 billion

$78 billion $60 billion

$62 billion

Non-Malignant Asbestos Claimants File Most Claims, Get Most $$$

DISTRIBUTION OF CLAIMS

1991-2000

ALLOCATION OF COMPENSATION

1991-2000Lung & Other

Cancers7%

Non-malignant

90%

Meso-thelioma

3%

Source: RAND, Tillinghast-Towers Perrin

Lung & Other

Cancers18%

Non-malignant

65%

Meso-thelioma

17%

National Security & Defense Issues More Important in Post 9/11 Era

War on Terrorism

Terrorists & Terrorism

Expansion of War Is Iraq Next?

Insurers forced to cover losses over which they have no control, little knowledge and

that properly rest with public sector

No regulatory “compass” for this issue.

THE ROLE OF GOVERNMENTS IN IN INSURANCE IN THE

21ST CENTURYIs Traditional’ Regulation is Archaic?

Focus on Convergence of Sectors

Conclusions

Is Insurance Regulation Becoming Marginalized

Are Insurance Regulators Overshadowed?

• Efforts to modernize insurance regulation progressing more slowly than world in which insurance operates

• Approaching time when non-insurance regulators have more influence over insurance industry than non-insurance regulators

• Impact of non-insurance policy (war on terror, Iraq) & non-insurance regulatory decisions (e.g., SEC) on industry becoming more pronounced (corp. governance)

• Monetary/fiscal policy decisions are more critical than ever to insurers (esp. life) in convergent world

Core Principals ofInsurance Regulation (IAIS)

• System of insurer licensing

• Standards for corporate governance

• Standards for capital adequacy/solvency

• Rules governing assumption of risk by insurers

• Authority to monitor/conduct on-site inspections

• “Principles” applicable to intl./cross border nature of global insurers

• Power to take remedial action at problem insurers

Source: Holfeld, Knut, “Comments of Global Regulation,” Geneva Paper on Risk and Insurance,January 2002.

Focus on Regulatory Convergence is Insufficient

Are Insurance Regulators Overshadowed?

• Much of the focus on modernization of insurance regulation in recent years has focused on convergence

• While convergence proceeds (domestically and internationally) there is no push for a global “super regulatory authority”Practical/political impossibility even within US/EU for now

• Regulatory modernization is a necessary but not sufficient condition for regulatory relevance

ConclusionsMaintaining Relevance in the 21st Century

• Cross-sectoral efforts are underway (acknowledges realities of convergence), and work with groups like Basel Committee, IMF and World Bank are important, but…

• Sphere of insurer regulatory influence is under siege by outside forces—often beyond regulator control

• Regulators must achieve a delicate balance of achieving effective regulation without stifling innovation in insurance

• Many government policymakers/lawmakers and non-insurance regulators know very little about the insurance industry—must be educated.

Insurance Information Institute On-Line

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