Vaughan.Crisis - Old Version

This reading by T. Vaughan, The Economic Crisis and Lessons from (and for) U.S. Insurance Regulation covers theories that could explain regulatory failures leading to insolvencies. It then discusses the structure of U.S. insurance regulation within the context of those theories.

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Study Tips

The Vaughan reading was on the syllabus for several years. Then it was removed for a few sittings. Then it was put back on for 2019.Fall. Not sure why. Anyway, it's pretty straightforward memorization. There's a history of exam problems but there are also some likely questions that have not been asked frequently (or at all). You can see the repeated questions from the BattleTable, but you should also pay attention to the lists from the following subsections:

• Lessons from State Insurance Regulation
• Lessons for State Insurance Regulation

This reading is easy points on the exam but it will take more time than you think to memorize these facts reliably.

Estimated study time: 1 day (not including subsequent review time)

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• checks & balances in a regulatory system
• regulatory failure - reasons for
• preventing failure
• miscellaneous facts that also relate to general knowledge: causes of insolvency, rate regulation, solvency regulation, RRGs

Questions held out from Fall 2019 exam: #3. (Skip these now to have a fresh exam to practice on later. For links to these questions, see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
E (2019.Spring #3)	Porter.12-Insolvency	Porter.12-Insolvency	regulatory intervention: - reasons for delay
E (2018.Spring #3)	regulatory failure: - forbearance (defn)	regulatory failure: - forbearance (causes)	regulatory failure: - forbearance (effects)	regulatory failure: - forbearance (RBC actions)
E (2017.Fall #3)	checks & balances: 2 - in a regulatory system	checks & balances: - RRGs (see GAO.Report)
E (2016.Spring #3)	regulatory failure: - reasons for	checks & balances: 2 - in a regulatory system	preventing failure: - relate (b) to (a)
E (2013.Fall #3)	rate regulation: 1 - reasons (Porter.8-Rates)	solvency regulation: - reasons	rate/solvency regulation: - overlaps / conflicts	state/federal overlap: - advantages / disads
E (2013.Fall #5)	regulatory failure: - reasons for	checks & balances: 2 - in a regulatory system	preventing failure: - relate (b) to (a)	federal bailouts: - discuss likelihood

¹ Parts (a), (b), (c) of this question are really just general knowledge. They are the types of questions where you could take an educated guess and get it right. Part (d) is more specific to the content of this reading.

² The examiner's report lists "duplication", "peer review", and "peer pressure" as separate answers for strengths of the U.S. regulatory system. This changed for E (2019.Fall #3) however where all 3 items were considered a single strength. To receive full credit on the 2019.Fall exam, you had to list 2 additional items. In other words what was considered an acceptable answer changed. Please see this forum discussion for further details.   (shout-out to PA!)

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In Plain English!

Intro

There's a fascinating story about an insurance fraudster Martin Frankel. He operated during the 1990s in 6 states: Arkansas, Mississippi, Missouri, Oklahoma, Tennessee, and Virginia, and his theft totaled 200 million. But the Mississippi DOI was the only regulatory body that noticed the fraud. This is a great example of the value of duplication in regulation. See this forum post for a link to podcast on this guy. (shout-out to kmo474!)

Contrast this with the Bernie Madoff financial fraud case. In that case, the SEC (Securities & Exchange Commission) was the relevant regulatory body. The fraud was financial and not specifically insurance and there was no regulatory duplication at the state level as in the Frankel case. Madoff's thievery totaled 10 billion before the whole scheme collapsed in on itself.

Now it wouldn't be fair to say that regulatory duplication would definitely have changed the Madoff outcome, but it is fair to say that duplication of effort should be part of any robust regulatory system. Note that there's a cost to regulatory duplication because you potentially have multiple bodies doing the same job, but there's also the benefit that fraud may be caught significantly sooner.

Con-men and con-women are captivating individuals. They have to be. It's their wit and charm that distracts us from the deception. If you're tired of studying, watch the true story of con-man Frank Abagnale in the movie Catch Me If You Can. It stars Leonardo Di Caprio as the con-man and Tom Hanks as the FBI agent. I was totally rooting for Di Caprio even though I knew he was the bad guy! The vast majority of us would feel exceedingly uncomfortable perpetrating even 1% of what this guy did. I wonder what's different about them that makes them able to lie and cheat so effortlessly, and always with a smile? Another great film about a con-man is the story of Steven Jay Russell in I Love You Phillip Morris. This one stars Jim Carrey and Ewan McGregor.

Another good example is Elizabeth Holmes and her now defunct company Theranos.

Lesson: Con-men and con-women have always been among us. They're smart, witty, and charming. But they hurt people. Just and fair application of laws & regulation is how we protect ourselves.

Effectiveness of Regulation

The source text states explicitly that the main test of regulation’s success is its effectiveness in achieving its objectives in these 4 areas: [Hint: protects-PIED  ← shout-out to NB!]

• protecting Policyholders
• protecting Investors
• protecting Economy, in general
• protecting Depositors

It's interesting that this was asked in part (a) the following exam question: (how to test effectiveness of an insurance regulatory framework)

E (2019.Fall #3)

But the answer provided in the examiner's report was completely different from what was stated in the source text. The reason is that the topic is also discussed in another syllabus reading, NAIC.Solvency - Section 1 - Paragraph 15: Judging Regulatory Effectiveness, and that's the source the answer given in the examiner's report. (shout-out to bg!) If you were to try to answer the question using the Vaughan reading, this might be what you could say:

• protecting policyholders

- quality of customer service (# of complaints and disputes)

- reduction in probability of insolvency (identification & rectification of potential problems)

- compensation in the event of an insurer insolvency

• protecting depositors

- I asked Alice the Actuary what this means but she didn't know. She thinks it's an error because the term "depositors" usually refers to banking rather than insurance.

• protecting investors

- ensure regular and accurate financial reporting

• protecting the economy generally

- ensure a healthy & competitive market

- promotes availability & affordability

- benefits of regulation should be greater than the costs

I think you would get most of the points for this answer, but again, take a look at NAIC.Solvency - Section 1 - Paragraph 15: Judging Regulatory Effectiveness to see the answer the graders seemed to be looking for.

Why Regulation Fails

This is a simple section that will definitely be tested on future exams.

Question: identify 3 concepts related to regulatory failure [Hint: FFC]

• regulatory Fallibility
• regulatory Forbearance
• regulatory Capture

Question: briefly describe the concept of regulatory Fallibility

definition: the regulator F**ked up, or more politely: regulators are human and humans make errors

(includes things like miscalculating IRIS ratios, missing deadlines, losing paperwork, smoking weed in the break room...)

Question: briefly describe the concept of regulatory Forbearance

definition: failure of a regulator to intervene promptly in a troubled company

reasons:

• company may recover without intervention (not all troubled companies go bankrupt)
• company may object to intervention (Ex: because regulator may want a prompt increase in capital or decrease in debt)

consequences:

• if company recovers → no consequences
• if company doesn't recover → impact to policyholders and strain on guaranty funds may be worse than if regulator had intervened earlier

   - data shows that troubled companies often take increased risks when trying to recover

   - these increased risks could be successful or they could make a bad situation worse.

Question: briefly describe the concept of regulatory Capture

definition: tendency for a regulator to assume the mindset of an interest group

reasons:

• the interest group may be good at influencing a regulator
• political interference

consequences: (same as for "forbearance" above)

• if company recovers → no consequences
• if company doesn't recover → impact to policyholders and strain on guaranty funds may be worse than if regulator had intervened earlier

Alice summed it up nicely: (the 'scores' are totally made up just to illustrate the point)

In an ideal fantasy world:

• the regulator has perfect information (score = 100%)
• the regulator knows exactly what to do (score = 100%)
• the regulator takes action at precisely the right time (score = 100%)

In the messy real world:

• the regulator has imperfect information (score = 30%)
• the regulator doesn't know exactly what to do (score = 40%)
• the regulator takes action far too late (score = 20%)

The point is that regulators are fallible human beings. Some are better, some are worse, but nobody is perfect. Maybe someone should regulate the regulators? That's not such a crazy idea and it leads to the idea of putting checks & balances in the regulatory system. We'll discuss that in the next section.

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Structure of Insurance Regulation

This is the other main topic that seems to be asked on this reading.

Update for 2019.Fall: Prior to E (2019.Fall #3), the 5 strengths listed below were considered by the graders to be 5 separate answers. On the 2019.Fall exam however, the graders considered "Duplication", "Peer Review", and "Peer Pressure" to be a single item. To receive full credit, the graders required 2 additional items. Based on the source reading, I believe the 5 items below are indeed distinct items but if the question appears again on an exam, it might be wise list them together then provide 2 additional items just to be safe.   (shout-out to PA!)

Question: identify checks & balances in the U.S. insurance regulatory system for limiting regulatory failures [Hint: D2P2M]

D²

Duplication

• multi-state insurers are subject to regulation in each state of operation
• 1 state may missing warning signs of a troubled company
• but it's unlikely that all states would miss the warning signs

Diversity of perspective

• different regulators have different perspectives regarding regulation
• some prefer strong regulation (higher costs but protects consumers)
• some prefer weak regulation (lower costs but can be harmful to consumers)
• competing perspectives encourage centrist solutions (prevents overregulation / deregulation)

P² (sometimes the examiner's report considers these 2 items to be the same thing)

Peer review

• NAIC coordinates peer review groups FAD & FAWG

• FAD = Financial Analysis Division

→ analyzes nationally significant insurers

→ refers unusual findings to FAWG

• FAWG = Financial Analysis Working Group

→ consists of 16 highly experienced financial regulators

(not the same as regulatory duplication by state regulators)

Peer pressure

• any state can investigate or take action against any insurer operating in their state
• such action by 1 state can pressure other states to do the same

M

Market discipline

• state-based regulation cannot easily access federal bailout funds

(eliminates moral hazard of relying on federal government)

• provides incentive for states to exercise strong regulation

I can remember this hint, D²P²M, for checks & balances because the "squared" function on the D and the P is like a "check & balance" on each of them. (The pattern doesn't work for the M so you just have to remember that separately.)

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Lessons from State Insurance Regulation

Insurance companies fared relatively well during the financial crisis of 2007-08. This shows that the state-based system of insurance regulation with its various checks & balances is a good model. Financial systems, including insurance, are becoming increasingly globalized. Can we take elements of the U.S. state-based system and expand it to the global stage?

Question: identify 4 elements in building an effective global insurance regulatory system [Hint: TSAR]

Element 1: Trust

• regulators must trust each other

   U.S.: accomplished through NAIC accreditation

   global proposal: IMF Financial Sector Assessment Program and G20 peer review

Element 2: Share

• regulators in different countries must share information

(this is the greatest challenge because domestic regulators want to protect domestic industries)

Element 3: Action

• other countries must be able to take action against an insurer

(if dissatisfied with actions by other regulators)

Element 4: Resolution

• mechanism of resolution for bankruptcies

(must be fair to all countries involved)

This list strikes me as very important. Globalization is a core issue facing all of us. Do we need a global TSAR for insurance regulation?

Lessons for State Insurance Regulation

Any regulatory system must evolve with the times. Even though the checks & balances of the U.S. state-based insurance regulatory system has functioned well in the past, we should always be striving to increase efficiency and coordination.

Question: identify areas that regulators have targeted for improvements to the U.S. insurance regulatory system

• rating agencies: review reliance on rating agencies in the RBC system
• securities lending: new reporting requirements for securities lending
• unregulated affiliates: impact on insurers

Aside from these targeted improvements, there is also concern surrounding the system's ability to interact with entities outside the system, like Congress or regulators outside the U.S.

Question: identify the NAIC's 5 principles that any national regulatory structure should possess [Hint: STarCH] because you need structure in your white-collar shirt as a regulator!  ←shout-out to marquaty!

Standards: (2 principles)

• uniform where appropriate but local where necessary
• set & enforce at state level

Taxes & fees:

• states should still be able to collect taxes & fees

→ ar ← not part of the mnemonic - these are "infill" letters so that we could spell the word "starch"

Collaboration:

• encourage collaboration with international bodies

Holding companies:

• state regulators should have equal standing with other regulators regarding holding companies

These principles are designed to encourage uniformity and reciprocity. The first 4 make sense to me but the last one about holding companies seems a bit random. You probably have to get into this topic more deeply for it all to make sense.

I couldn't think of a good memory trick for the lists in this section, but luckily marquaty came up with one. (Personally, I don't like starch in my shirt collars, but I'm not a regulator!) Sometimes I make up a dumb story that ties everything together. And if I can't do that, I just flat-out memorize it with brute force repetition. (It's good to have several different strategies for learning that you can call up when needed.)

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A Few More Exam Problems

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