Insurance in the United States is regulated by the individual states and not by the federal government, a principle embodied in a federal statute, the McCarran-Ferguson Act of 1945. In recent years large insurers and their trade associations have pushed hard for the creation of a federal insurance regulator to be responsible at least for the regulation of insurers that operate on a national and international basis. Congress has shown an increasing willingness to consider such a change, and bills to allow insurers the option of being regulated by the federal government rather than the states have been introduced in the past two sessions, although they have yet to come to a vote in either chamber. There is vigorous opposition to such a change from state regulators, state legislators and some elements of the insurance industry itself.

The National Association of Insurance Commissioners (NAIC) is a private trade association whose members are the 57 elected or appointed state insurance regulators (one each from the 50 states plus the District of Columbia, Puerto Rico and the territories). For more than 130 years the NAIC has coordinated activities among the various state regulators, developing model laws and regulations, establishing standards for financial solvency, accrediting state insurance departments and, in recent years, building systems for the uniform electronic reporting of insurance company data. In an intense effort to head off the creation of a new federal insurance regulator the NAIC has sought to portray itself as in essence an existing state-based national regulator, making the creation of a new federal agency unnecessary. As the NAIC itself recognizes, however, it lacks the legal authority to be a national regulator. To remedy that critical defect the NAIC is preparing to ask Congress for the enactment of a federal law that would give it regulatory authority, in particular the ability to force states to comply with its rules and decisions.

The proposal to clothe itself with federal regulatory authority presents the NAIC with a dilemma: how can it continue to function as a private organization carrying out the wishes and objectives of its members (all of whom are state officials operating under state laws) while also performing the role of a national public agency empowered by federal law? Judging from its initial efforts at drafting federal legislation to that end, the NAIC is very far from solving this conundrum. In fact, there may be no viable solution.

Although there are examples-often pointed to by the NAIC-of private corporations carrying out federal regulatory activities, such as the Financial Industry Regulatory Authority (FINRA), which is a self-regulatory organization formed by a merger of the National Association of Securities Dealers (NASD) and parts of the New York Stock Exchange (NYSE), such organizations are fundamentally different from the NAIC. Their members (securities dealers in the case of NASD and listed corporations in the case of the NYSE) are private entities, not state officials. Moreover, FINRA operates under the regulatory supervision of the Securities and Exchange Commission (SEC), a federal agency charged with enforcement of federal securities laws. The NAIC, in contrast, is an organization of state officials who carry out regulatory activities under the authority of diverse and not always consistent state laws. Even if state regulators were willing to see their trade association imbued with federal authority that includes the power to preempt state laws (and there is certainly resistance on the part of at least some of the NAIC membership to this notion), it is doubtful that constitutional principles would permit it. The NAIC's problem is pervasive and goes to the heart of what the organization is all about. The issue has been brought into sharp focus recently, however, by the effort of the NAIC to establish a single regulatory authority for reinsurers operating in the United States.

The Regulation of Reinsurers  

The NAIC is starting its process of redefinition as a national insurance regulator with what would appear to be a relatively easy task, the regulation of reinsurers. Reinsurers are typically large financial institutions that operate throughout the country and, often, throughout the world. Unlike primary insurers, reinsurers do not deal with the general public but rather with sophisticated primary insurers (ceding companies). There is general agreement throughout the insurance industry that reinsurers should not be subject to multiple regulators applying different laws. In fact, state regulators in the United States do not regulate reinsurers directly (except for those domiciled in their jurisdictions), but rather indirectly by providing credit for reinsurance to primary insurers. Each state has a law requiring insurers operating in the jurisdiction to provide proof of financial solvency; that is, they must show that they have sufficient assets to pay future claims filed under policies written in the jurisdiction. Reinsurance purchased by the ceding insurer can be counted toward the required asset level, but only if the regulator is satisfied with the financial strength of the reinsurer. If a ceding company cannot treat reinsurance purchased from a reinsurer as an asset on its books, it is not likely to do business with that reinsurer.

The current NAIC model "credit for reinsurance" law, which has been enacted by each state, requires that non-U.S. reinsurers-that is, those that are not domiciled in any U.S. jurisdiction-post 100% collateral on U.S. risks in a U.S. bank in order for ceding companies to be able to treat reinsurance purchased from those companies as assets. Some of the world's largest reinsurers, such as Lloyd's and Hannover Re, are not domiciled in a U.S. jurisdiction, and these giants of the industry have complained for years about the need to tie up capital in the form of collateral in U.S. banks. In response the NAIC has drafted a "framework" for a proposed revision of the model "credit for reinsurance" law that would change the collateral rules so that well-financed non-U.S. reinsurers could operate in the United States with less than 100% collateral or, in some cases, zero collateral. The "framework" proposal was approved by the NAIC in December of 2008.

The "framework" proposal would allow non-U.S. reinsurers to operate throughout the United States with a single regulator, a "port of entry" state that it would choose from among state regulators approved for this purpose by the NAIC. (Domestic reinsurers would similarly be able to operate nationwide with a single regulator, namely their "home" state, the jurisdiction in which they are domiciled.) The problem, of course, is that the NAIC has no way to enforce its "single regulator" proposal. Currently each state makes its own determination of whether insurers operating in its jurisdiction are sufficiently capitalized for the risks they insure in that state, which includes deciding whether it will grant credit for reinsurance they have procured. Would a state-especially one with a substantial insurance market, such as California-be willing to forego its right to assess whether an insurer operating in its jurisdiction has sufficient assets, including reinsurance? Would it be willing to cede that authority to another state? Would it be willing to subordinate its sovereign authority and responsibility for protecting insurance consumers in its state to a private organization, the NAIC, even though it is a member of the NAIC? And if it were not willing to do so, could it be required to do so under constitutional principles?

The NAIC "framework" proposal calls for a federal law that would preempt the authority of any "host" state to deny credit to a ceding company for reinsurance purchased from a reinsurer regulated by a "home" or "port of entry" state approved as the reinsurer's single regulatory state by the NAIC. That is, the NAIC, while remaining a trade association of state insurance regulators, is asking the U.S. Congress to enact a law that would preempt the authority of state regulators to disagree with the decision made by another state regulator anointed by the NAIC to be the single regulator for a particular reinsurer. The NAIC is seeking to clothe itself in a federal law that would allow it to override the authority of a statutory state insurance regulator.

Aside from the astounding and unprecedented nature of this effort by the NAIC, can Congress lawfully give the NAIC the authority it wants? To answer that question it is necessary to look closely at what the NAIC is proposing. The NAIC has drafted and circulated for comment a proposed federal statute, the "Reinsurance Regulatory Modernization Act of 2009." This is still an early draft and there is no Congressional sponsor for the legislation as of yet. But an analysis of the provisions of this proposal, and the sharp industry comments that it elicited, highlights in stark fashion the dilemma faced by the NAIC as it seeks to position itself as a national insurance regulator.

The Draft "Reinsurance Regulatory Modernization Act of 2009" The first draft of the "Reinsurance Regulatory Modernization Act of 2009" was circulated on March 24, 2009, to insurers and insurance trade associations for comment. Many comments were received, most highly critical of various aspects of the bill, and a revised draft was circulated by the NAIC on July 27, 2009. The revised version attempts to meet many of the objections raised to the earlier draft but generally falls short of doing so.

In the original version the bill would create a National Association of Insurance Commissioners Reinsurance Supervision Review Board (Board) as a nonprofit corporation owned by the NAIC that would "not be an agency or establishment of the United States or any State Government" and that would have the power to create two classes of reinsurers ("National" and "Port of Entry"), to adopt standards proposed by the NAIC for regulating each type, and to choose "home" or "port of entry" jurisdictions according to criteria set by the NAIC that would be the sole and exclusive regulators for each reinsurer under their jurisdiction. All other state laws and regulations, to the extent they are inconsistent with this law, would be preempted.

Virtually every commentator on the draft pointed out that the structure of the bill was very likely unconstitutional under a number of provisions of the U.S. Constitution, including the Appointments Clause (Art. II, Section 2, clause 2), which empowers the President of the United States (sometimes, but not usually, with the advice and consent of the Senate) to appoint all officials authorized to exercise executive power under laws enacted by Congress, and the Tenth Amendment, which reserves for the states powers not given explicitly to the Congress, and which has been interpreted by the Supreme Court to prohibit the federal government from compelling states to enforce federal statutes. In addition, numerous commentators noted that, as a private corporation, owned by the NAIC, the Board would not be subject to any of the limitations and restrictions applicable to public officials under the Administrative Procedure Act, the Freedom of Information Act and other federal statutes, and that the Board's actions would therefore violate the "due process" clauses of the Fifth and Fourteenth Amendments.

In an attempt to circumvent these constitutional problems, the revised version of the bill calls for the President of the United States to appoint all 15 members of the Board, with the advice and consent of the Senate, 10 of whom would be sitting state insurance commissioners nominated by the NAIC and five of whom would be federal officials from the Department of the Treasury, the Department of Commerce and the Office of the United States Trade Representative. But the Board would still be dominated by state insurance commissioners, who would outnumber federal officers two to one. Moreover the language would require the President to appoint the 10 persons nominated by the NAIC, including one he would designate as the chairperson of the Board. The President's role, then, would be ministerial and would not involve an exercise of discretion. It is clear that the Board would still be an operation controlled by the NAIC. It is likely therefore to still be unconstitutional, even assuming Congress could be induced to enact such a law. The language of the first draft saying that the Board is a private nonprofit corporation owned by the NAIC and not an agent or instrumentality of the federal or any state government has been deleted in the revised version but not replaced, leaving open just what kind of entity the Board would be and on whose behalf it would be acting.

Moreover the revised version of the bill would still preempt inconsistent state laws, and would require that states seeking to qualify as "home" or "port of entry" jurisdictions adopt standards set by the Board. Thus the Tenth Amendment problem would remain.

Finally, the revised draft contains a new "Right of Review" section that would allow an aggrieved ceding insurer to seek review by the Board of an adverse action taken by any state official, under review standards to be established by the Board. The ceding company would have the right to appeal a final adverse decision of the Board to federal court, and the failure of the Board to make a final ruling on an appeal within six months would be considered a final disposition for purposes of such an appeal. The draft bill is silent as to whether such a procedure would replace or abrogate the conventional review of the actions of a state official in state court under the state's administrative procedures act. A state would also have the right to appeal to federal court the denial of its application to be certified as a "home" or "port of entry" jurisdiction. But there is no provision that would subject the Board to the federal Administrative Procedure Act or to any other federal "due process" statutes. Nor is there any language that would apply the federal (or any state) Freedom of Information Act to the Board. It is likely, therefore, that the revised version does not resolve the Fifth and Fourteenth Amendment issues.

Can the Reinsurance Regulatory Modernization Act Be Made Constitutional?  

For the concept of a Reinsurance Supervision Review Board to work, including having the authority to preempt inconsistent state laws, the Board would have to be set up much like a regular federal agency, along the lines of the Securities and Exchange Commission or the Federal Communications Commission. Such entities are subject to the federal Administrative Procedure Act, the Freedom of Information Act and other laws designed to protect citizens from the arbitrary exercise of governmental power. But if the bill is drafted that way, what becomes of the role of the NAIC? The answer is that it would be diminished, if not extinguished.

And that would not be surprising. The NAIC cannot have it both ways. It cannot both be a private trade association and a federal regulator. It cannot at the same time be both the agent of state regulators and the instrument of federal authority over the states. An agency that would have the ability to mandate a single regulator for reinsurers, preempting state laws that interfere with that goal, would for all practical and legal purposes be a federal insurance regulator, subject to the federal laws and oversight applicable to all federal agencies. But that is the very thing the proposed legislation is intended to prevent.

A federal law that has been on the books for decades, the Liability Risk Retention Act of 1986 (LRRA), established the concept of a single state regulator for qualified self-insurance mechanisms known as risk retention groups. Under that statute each risk retention group is subject only to the regulatory authority of its state of domicile; other state regulators are largely preempted from regulating it. A similar single state regulatory scheme-with other states preempted-would be made available to surplus lines insurers by the proposed Nonadmitted and Reinsurance Reform Act of 2009 that is currently pending in both houses of Congress. But these laws do not provide a regulatory role for the NAIC. Instead, where a non-regulatory (host) state tries to exercise regulatory authority over a risk retention group that has been approved by the domiciliary "home" state, the only remedy is to take the supposedly preempted regulator to court. The issue is not whether federal law can preempt state regulatory authority, or designate one state as the regulatory authority over an insurance entity and preempt other states. Congress can and has done so. Rather the question is whether the NAIC, as a private organization, can be empowered by federal law to make and enforce rules that preempt state authority. The answer to that question is probably no.


So that is the dilemma for the NAIC. A federal law that would provide for a single regulator for reinsurers, including preemption of inconsistent state laws, would mean the creation of a federal insurance regulator. And if that is true for reinsurance, for which there is a broad consensus in favor of a single regulatory regime, how much more difficult would it be to enact a federal law that would empower the NAIC to act as a national regulator in areas where there is no such broad agreement, such as personal insurance lines like auto and homeowners? The NAIC, as the trade association of state regulators, could play a supporting role for a federal regulator, as the developer of model laws and as the repository of experience, information and data from state insurance regulators upon which a federal regulator could base its regulatory decisions. But the NAIC cannot itself make regulatory decisions that override state laws. Only a federal regulator can do that.

The NAIC's fall meeting will be held this year the fourth week of September at the Gaylord National Harbor Hotel just outside Washington, DC. The Reinsurance Task Force will meet from 8:00 to 10:00 a.m. on the last day, Thursday, September 24, where discussion of the draft federal legislation is likely to continue