There is an excellent chance that Congress will enact significant financial regulatory legislation in 2010. But what, if anything, will this initiative mean for the insurance industry?

So far, the major reform proposals under consideration in both the House and the Senate treat insurance issues very gingerly. Language discussed in both chambers could subject insurance companies to "too big to fail" rules, but it is far from clear that any insurance company other than AIG—no matter how big— would meet the criteria for systemic risk. The bill approved by the House on December 11, H.R. 4173, contains a provision that would establish a new "Federal Insurance Office" (FIO) in the U.S. Treasury Department. That provision, however, is notable more for what it leaves out than what it includes. It would not put the federal government into the business of regulating insurance. In fact Representative Kanjorski (D-PA), the main sponsor of the FIO idea, has denied that there is any intent, hidden or otherwise, in the legislation to create a federal insurance regulator. Instead, the office would serve primarily as an information resource on insurance for Congress and federal financial regulators.

As set out in the House bill, the director of the FIO would be a career government employee appointed by the Secretary of the Treasury, not a presidential nominee subject to approval by the Senate. The office is given no direct authority over systemic risk in the insurance industry. The director would sit on the Financial Services Oversight Council, the proposed interagency group responsible for overall financial systemic risk, alongside a designated state insurance regulator, but as a non-voting member. Even in the area of insurance regulation generally conceded to be most appropriate for a federal government role—participation in international insurance regulatory conferences and agreements—the responsibility of the FIO director is circumscribed by the requirement in the bill that he or she consult with state insurance regulators and with the U.S. Trade Representative.

There is no Senate bill yet. A draft bill being circulated by Senator Dodd (D-CT) has a similarly restricted role for the new federal entity, which is called in the Senate draft the "Office of National Insurance."

Should we therefore conclude that the prospect for meaningful insurance regulatory reform is dead, and that the current state-based system of insurance regulation will continue as before? That would be a misreading of the tea leaves, in our view. The real situation is much more fluid. We see signs of genuine change on the horizon, even though enactment of an across-the-board Optional Federal Charter law is most unlikely.

Here are the clues:  

The National Association of Insurance Commissioners (NAIC) supports the creation of a Federal Insurance Office. Although much of the effort of the NAIC last year was directed at watering down the authority of the FIO contained in the Kanjorski bill and protecting the authority of state regulators over the business of insurance, simply by recognizing a need for the federal government to become involved in issues of insurance regulation, the NAIC has turned a historic corner. In the past, the NAIC has always opposed the very thought that the federal government might get involved with insurance issues. Now it recognizes and accepts that the globalization of the insurance industry and the need for uniform regulatory standards across national as well as state borders requires federal government involvement at some level.

But the NAIC has gone even further. It has proposed federal legislation of its own that would establish a National Insurance Supervisory Commission (NISC), to be created by the states under federal law, to establish and enforce uniform standards across state lines. That is a stark admission by the NAIC that the state regulators by themselves, even acting through their collective membership organization, cannot achieve the degree of uniformity in regulatory standards that the modern U.S. insurance community needs if it is to remain competitive in a global economy. While the draft NISC legislation is still a work in progress—and there are significant legal and constitutional issues involved in whether state regulators can be part of a federal regulatory structure—the genie is out of the bottle and cannot be put back again. The discussion has shifted irrevocably from the question of whether the federal government should be involved in regulating the insurance industry to the questions of how and to what extent the federal government should be involved.

The bailout of AIG has focused congressional attention on the lack of federal involvement in insurance regulation. Even though the NAIC makes a plausible argument that AIG's problems were not related to its insurance activities—that it was the company's unregulated trading in derivatives on the London market that caused the problem, not its state-regulated insurance operations, all of which remained and remain healthy— nevertheless the fact is that AIG has required many billions of dollars in taxpayer-financed relief to stay afloat. Congress and the Obama Administration will continue to look for a way to prevent such a situation arising again and will not be satisfied that state insurance regulation alone will provide the necessary comfort level. After all, AIG is not just a global insurance company but a huge financial conglomerate engaged in many different kinds of businesses in every state and many foreign countries. Even if all of its insurance activities are sound, it still poses a systemic risk.

The insurance industry will continue to press for a greater federal government role in the regulation of insurance, even in the face of strong opposition from state legislators, governors and insurance commissioners. The ability of insurers to opt out of the state regulatory system when they choose to do so—the holy grail of insurance regulatory reform—is not a realistic solution now or in the near future. But that does not mean that valuable and genuine reform is not possible.

As in any major legislative debate, the ultimate outcome will depend on whether a negotiated solution can be found that provides all of the major players with enough of what they want to enable them to strike a deal. That means that insurers, along with all the other parties in interest, must think about bottom line questions. What is truly essential? What can we live without?

The "insurance industry" is an enormous, multi-dimensional (as well as multinational) business. Leaving aside the national debate over health insurance, which is about to be addressed in a separate piece of reform legislation, much of the criticism directed at insurers concerns personal lines insurance—in particular, private passenger auto and residential homeowners—a relatively small slice of the entire insurance industry where insurance companies deal with individual, unsophisticated policyholders at the retail level. When elected and appointed officials talk about "consumer" issues, they usually mean the individual families who purchase single policies covering their homes and cars. Membership-based consumer organizations, such as Consumers Union and AARP, as well as self-appointed "consumer advocates" and state attorneys general, also focus almost exclusively on this portion of the insurance market. Yet the concern for this one class of insurance purchasers is driving the entire debate on regulatory reform.

A more thoughtful and nuanced parsing of the insurance industry will readily reveal areas where there are no major obstacles to significant reform. Although the solvency of insurance companies is always an issue, do politicians and consumer advocates really care about insurance purchased by large corporations? Do they win votes by criticizing treaties between major insurers and reinsurers? Do they worry about how disputes among insurers, or between insurers and their commercial policyholders, get resolved? In all of these areas, which are very important to insurers and to the broader business community but have little political charge, it may be possible to get uniform, national regulation or even—in some cases—little or no regulation at all of individual transactions. But such reforms may require assurances from the industry regarding the regulatory treatment of individual insurance policies purchased by ordinary private citizens.

So far, the debate over insurance regulatory reform has tended to look at the insurance industry as a monolith, rather than recognizing the great diversity and complexity of its various components. "We need to protect insurance consumers," is the cry, as if all purchasers of insurance need or want government protection. "Insurance transactions must be regulated by the states." All insurance transactions? By each and every state? "Variations in state laws require separate state oversight of insurance forms and rates." Are all insurance transactions subject to variability in state laws? Can't some kinds of insurance policies be treated on a national, uniform basis, even if not all of them can?

By looking at the component parts of the insurance industry separately, it may be possible to design a regulatory system that takes account of differences in the size and sophistication of the purchasers, the nature of the products being bought and sold, and the variability—or lack thereof—of applicable state laws and policies, and to subject each kind of insurance transaction to those regulatory requirements that are best suited for the purpose. It may make sense to have some portions of the industry regulated at the federal level, or subject to uniform national standards, while leaving retail transactions with individual purchasers of insurance subject to state regulation. Why does there have to be a single answer, a single way of regulating, for every aspect of the insurance business? Does reinsurance really require the same level of individual state scrutiny as workers' compensation insurance, for example, where state laws vary widely and states mandate the coverage that must be offered?

State regulation of insurance is not holy writ. It is not even constitutionally required. It is based on a single congressional statute, the McCarran-Ferguson Act of 1945. Perhaps it is time to revisit that ancient law, now more than half a century old, and to update it in a way that takes account of the vast transformations in the insurance industry that have taken place over the past 65 years. Doing so requires a hard-headed, unsentimental view of what insurance transactions are all about. Insurance regulators and politicians need to recognize that large corporate purchasers of insurance, with their teams of lawyers, actuaries and brokers, do not need the same kind of government intervention and protection as do first time purchasers of homeowner's insurance. At the same time, insurers need to recognize that the playing field is not level for someone buying private passenger auto insurance from a multi-billion-dollar international insurance company, and that government review at the state level may be warranted to ensure that such consumers are properly protected.

The recent financial crisis has forced Congress to focus on issues of financial regulatory reform. Reform legislation is likely to be enacted in 2010. Will changes in the way insurance is regulated be part of that effort? The prospect presents both dangers and opportunities. A "winner takes all" approach that either leaves the present state regulatory system intact or abolishes it in favor of a federal regulator increases the dangers and limits the opportunities. A far more productive approach would focus on the wide variability in the need for government intervention in insurance transactions, supporting state regulation when appropriate, national or federal regulation when that makes sense, and even regulatory exemption when no public purpose is served by government review.