Vaughan.Crisis

Reading: “The Economic Crisis and Lessons from (and for) U.S. Insurance Regulation,” Journal of Insurance Regulation, Fall 2009, pp. 6-13.

Author: Vaughan, T. (Note that the author's name is spelled incorrectly in the CAS syllabus.)

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VIDEO → (4:30) → Lessons for Insurance Regulation - General Overview    (Click here for all currently available videos.)

BA Quick-Summary: Lessons for Insurance Regulation Here we examine how U.S. Insurance Regulation played a part in the 2007/08 financial crisis and what changes are needed to prevent future issues. It talks about the importance of focusing on systemic risk and having a way to handle big, risky institutions. The article also highlights the strengths of the U.S. state-based insurance regulation system, like checks and balances and peer reviews, but also points out that there's room to improve efficiency and coordination among regulators.

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Multiple Choice (mini BattleQuiz 4) ← for general review of topic

Study Tips

The Vaughan reading is straightforward memorization but it will take more time than you think to memorize these facts reliably. Otherwise, it's easy points on the exam so make sure you spend enough time on it.

Changes for Fall-2023: These sections have been removed from the syllabus.

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.

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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.

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

This section - Effectiveness of Regulation is no longer on the syllabus because it is already covered in: NAIC.Solvency - Section 1 - Paragraph 15: Judging Regulatory Effectiveness Please continue reading here: Why Regulation Fails

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 ]

• 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. 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 Fudged it 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 (information score = 100%)
• the regulator knows exactly what to do (knowledge score = 100%)
• the regulator takes action at precisely the right time (action score = 100%)

In the messy real world:

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

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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A Few More Exam Problems

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