Principles for Insurance Regulation: An Evaluation of Current Practices and Potential Reforms

Abstract

The recent financial crisis and its cascading effects on the global economy have drawn increased attention to the regulation of financial institutions including insurance companies. While many observers would argue that insurance companies were not significant contributors to the crisis, the role of insurance companies in the financial economy and their potential vulnerability to systemic risk have become matters of considerable interest to policy-makers and regulators. In this context, this paper examines the basic economic principles that should govern the regulation of insurance and employs these principles in assessing current regulatory practices and potential reforms. Specifically, it articulates the basic rationale for insurance regulation, which is the remediation of market failures where regulation can enhance social welfare. In insurance, the principal market failures that warrant regulatory intervention are severe asymmetric information problems and principalagent conflicts that could lead some insurance companies to incur excessive financial risk and/or engage in abusive market practices that harm consumers. This provides an economic basis for the regulation of insurers' financial condition and market conduct. At the same time, the regulatory measures that are employed to correct market failures should be efficient and effective. Judged against these principles, the systems for solvency and market conduct regulation in the United States warrant significant improvement. There appears to be little or no justification for regulating insurance rates in competitive markets and the states should move forward with full deregulation of insurance prices. The EU appears to be much farther ahead in terms of implementing best practices in the regulation of insurers' financial condition under its Solvency II initiative. It is also much closer to the desirable goal of full price deregulation than the United States.

Systemic Risk in the Insurance Sector: A Review and Directions for Future Research

“…The Geneva Association () and Klein (), in addition to Cummins and Weiss (, ), argue that there is also no systemic risk from life insurance or annuities. Their main argument is that this line of business does not have a strong impact on other financial market participants or on the economy in general in the case of bankruptcy.…”

Regulations, profitability, and risk-adjusted returns of European insurers: An empirical investigation

“…For example, Dickinson (1998) argues that restrictions may introduce difficulties in dealing with some of the underlying risk of life insurance business, such as interest risk on annuities and term policies. Klein (2011) points out, however, that despite various theoretical reasons for which a principles-based approach could be preferred, in practice the success of this approach depends heavily on the principles and standards that are set and the competence and motivation of regulators to take corrective action when it is needed. Furthermore, compliance with limits on portfolios is more readily verified and monitored by supervisors than by prudent person rules (Davis, 2002).…”

Recent Research Developments Affecting Nonlife Insurance—The CAS Risk Premium Project 2011 Update

“…Discussion continues as to the use of market-consistent valuation techniques, especially in light of the financial crisis. With Solvency II, the EU appears to be much farther ahead in terms of implementing best practices in the regulation of insurer financial condition compared to the United States (Klein, 2011). Moreover, the structure and principles of insurance regulation in Canada appear to be of interest, since Canada was the only G8 country that did not have to provide financial support to distressed financial institutions during the crisis (see Kelly et al, 2011).…”