By Aaron Klein
It is in vogue to compare financial regulators to cops on the beat. While the image has an understandable appeal, especially in the wake of the financial crisis, it doesn’t paint the whole picture. Instead, let’s consider a different analogy, that of a food safety inspector.
When you buy meat at the supermarket you probably don’t think twice about its safety. Government regulation of meat, spurred by the writings of Upton Sinclair more than a century ago, solved what was then a rampant food safety problem and laid the foundation for what has become a modern market success.
However, imagine that your beef was not inspected by a trained beef inspector, but instead by a poultry inspector. A poultry inspector will be alert to signs of avian flu but not necessarily hoof and mouth disease. Would you still have the same trust in the safety of your meat?
Something similar is happening with the regulation of financial products.
Among the many provisions of the 2010 Dodd-Frank Act that considerably improved financial regulation is new authority for the Federal Reserve to regulate “thrift holding companies,” which is how some large insurance companies are structured. Today a thrift is just another word for a bank, although many years ago that was not the case. It is not an accident that insurers are connected to thrifts. Some insurance companies were actually instructed by the federal government to buy thrifts and become thrift holding companies to be eligible for TARP assistance. In addition, the Financial Stability Oversight Council (FSOC), created by Dodd-Frank, is contemplating designating several insurance companies as systemically important, which would subject them to regulation by the Federal Reserve.
The Federal Reserve has been regulating banks for nearly as long as the USDA has been inspecting meat. However, it has never before regulated insurance companies, a task traditionally left to the states. Regardless of the wisdom of this structure, the new reality is that the Federal Reserve Board in Washington and many Federal Reserve regional banks face a new challenge: regulating insurance companies.
No big deal: Meat is meat, right? The Fed already regulates the systemically important banks, so one could just expect it to regulate large insurers. But just as cows don’t lay eggs, different animals are vulnerable to different diseases and present different risks. You don’t hear people in restaurants ordering chicken “medium rare.”
Two different businesses
Banks and insurance companies bear no more similarities than chickens and cows. They rely on fundamentally different business models with different balance sheets and revenue streams, meet different customers’ needs, have different legal and regulatory structures, and interact with each other and with the financial system in entirely different ways. Banks transfer timing risk; they allow depositors to have instant access to their funds, while making longer-term loans to consumers and businesses. Insurance companies, on the other hand, accumulate and pool risk. They allow people to transfer the financial risk of getting into a car accident, losing a loved one, or outliving their assets to a broad risk pool. Most of us who purchase insurance would be happy never to have to make a claim.
The first step to properly regulating each industry is to understand that these are different businesses with different models, laws and cultures. Under the trendy “systemic risk” regulatory framework, it is important to understand that insurance is fundamentally different from banking in terms of how – or whether – it could pose a “systemic threat” to the financial stability of the United States. Of course, insurance companies that operate like commercial or investment banks (think pre-crisis AIG) should be regulated like banks. If a chicken farm adds a few cows, both poultry and beef inspectors must show up.
Policymakers would be wise to recognize the differences between insurance and banking. Dodd-Frank did just this in creating the Federal Insurance Office to provide a better understanding of this important industry. Perhaps Dodd-Frank did not go far enough in creating a federal insurance regulator, but that is a different topic.
A prudent course would be for the Federal Reserve to undertake a Quantitative Impact Study to better understand the business of insurance before attempting to regulate it. As we learned in the last crisis, there are few things worse than a false sense of security coupled with inadequate regulation. The Federal Reserve and other financial regulators have spent a lot of time working with banks. Now is the time for them to realize that insurance is a different animal.
Aaron Klein is the director of the Bipartisan Policy Center’s Financial Regulatory Reform Initiative.