New York Superintendent of Insurance Eric Dinallo recently gave testimony before the United States Senate Committee on Banking,Housing and Urban Affairs in its hearing entitled “American International Group: Examining What Went Wrong, Government Intervention, and Implications for Future Regulation”. Dinallo was one of three panelists, the other two being Federal Reserve Vice-Chairman Donald Kohn and Acting Office of Thrift Supervision Director Scott Polakoff. While the title of the hearing would indicate that at least some federal legislators and regulators would like to use the AIG situation as an excuse to bring insurance regulation into the federal sphere, they found neither aid nor comfort in Superintendent Dinallo’s spirited defense of the state insurance regulatory scheme.
After clarifying for the panel that neither New York nor any other state insurance department is the “primary regulator” of the “huge global financial services holding company that does business in 130 countries”, only a portion of that business is insurance, Dinallo pinned the problem with AIG on one of AIG’s subsidiaries, AIG Financial Products “which had written credit default swaps, derivatives and futures with a notional amount of about $2.7 trillion, including about $440 billion of credit default swaps.” The Superintendent quoted Federal Reserve Chairman Bernanke who recently said “AIG had a financial products division which was very lightly regulated and was a source of a great deal of systemic trouble”, and referred to the Financial Products unit as “a hedge fund basically that was attached to a large and stable insurance company,” that “made huge numbers of irresponsible bets, [and] took huge losses.” Dinallo stated very clearly that “State insurance regulators are not perfect. But one thing we do very well is focus on solvency, on the financial strength of our insurance companies. We require them to hold conservative reserves to ensure that they can pay policyholders. That is why insurance companies have performed relatively well in this storm. One clear lesson of the current crisis is the importance of having plenty of capital and not having too much leverage.”
Thus, the Superintendent was very politely (and indirectly) saying to the committee essentially that we (state insurance regulators) did our job, maybe the fault in oversight occurred at the federal level.
Dinallo’s diplomacy in not pointing a direct finger at the federal government as the responsible regulator was contrasted by his “brick through the front window” style in emphatically attempting to stop any effort the committee may have had in using the AIG crisis to supplant state insurance regulation when he asserted “what happened at AIG demonstrates the strength and effectiveness of state insurance regulation, not the opposite. He further stated “The only reason that the federal rescue of AIG is possible is because there are strong operating insurance companies that provide the possibility that the federal government and taxpayers will be paid back. And the reason why those insurance companies are strong is because state regulation walled them off from non-related activities in the holding company and at Financial Products.”
The Superintendent also expressed opposition to the Optional Federal Charter (OFC) for insurers concept because it would create the opportunity for regulatory arbitrage. Dinallo spent some time in his prepared statement on the practice of securities lending and the role the practice played in AIG’s downfall. He said that the department has sent a Section 308 letter to all life insurance companies in September of 2008 to obtain information on their securities lending programs. The New York Department will continue to analyze the responses to the 308 letter and is currently in the process of drafting guidelines that will govern the size and scope of securities lending programs and best practices. I have reports that judging from some of the exchanges and questions posed, some were not entirely convinced by the Superintendent’s arguments. One exchange involved Dinallo’s assertion that even without the Fed’s intervention, the AIG insurance entities would have remained solvent. To that assertion, Federal Reserve Vice-Chairman Donald Kohn responded “I’m not sure I agree with Mr. Dinallo’s assessment.”
However, at least one Federal regulator acknowledged that some fault may lie in Federal hands. Acting Office of Thrift Supervision Director Scott Polakoff said that although the OTS had authority to oversee the activities of an AIG subsidiary the agency failed to exercise its authority properly. “We are clearly responsible, as the consolidated regulator” for AIG Financial Products, said Polakoff, and added, “We, in 2004, should have taken an entirely different approach that what we would up taking regarding the credit default swaps.” The origins of this crisis go back a long way and many hands are to blame. The financial services industry had advocated for years for a modernization of Depression Era restrictions which, they argued, had become anachronistic in the modern financial marketplace. Grahm-Leach-Bliley (GBL) was to be such a modernization. One effect of that legislation was to take state insurance and banking regulators out of the holding company operations. If state insurance regulators had responsibility for the whole company, would the risk of AIG Financial Products have been disclosed and tracked long before it exploded into the mess we now have? Wouldn’t that be a kick if the answer to the problem is more state insurance and banking regulation? What are the odds that the Senate Committee will report that recommendation?
New York Department Issues Guidance On Rebating And Inducements
On March 3, 2009, the Insurance Department issued “guidance and clarification” to its agent and broker licensees as to what kinds of services (often referred to as “value-added” services) may be provided to insureds or potential insureds without running afoul of the rebating and inducement provisions set forth in the New York Insurance Law. Circular Letter No. 9 (CL-9) has been issued, apparently, in response to numerous inquiries regarding these services. The Department acknowledged that the services provided in connection with the sale of insurance continues to evolve, but stated that the underlying principles remain unchanged, and can offer guidance to licensees.
CL-9 provides that “an insurer or insurance producer may not provide or offer to provide an insured or potential insured with any special benefit or discount, including any rebate from the premium, or any service or other incentive in conjunction with the sale of insurance, that is not specified in the policy or contract, or vice versa.” Further, the letter states that “The purpose of New York’s rebating and inducement provisions is to require an insurer or licensed insurance producer to provide insurance in a non-discriminatory manner to like insureds or potential insureds, and to prohibit such an insurer or insurance producer from providing an insured with any special benefit not afforded to other insureds or potential insureds.” (See, e.g.,McGee v. Felter, 75 Misc. 349 (Co. Ct. Kings Co., 1912)
The Department affirmed the fact that brokers may charge a service fee for such services, but an agent may not. Also, there are several services that may be offered by a producer without violating the anti-rebating and inducement provisions if the service directly relates to the sale and is provided in a fair and nondiscriminatory manner to like insureds, such as; risk assessments, including identifying the source of risk and strategies for eliminating risk; consulting; claims assistance (but not adjusting); Tax preparation of the annual employee benefit return; group policy information and forms; certain COBRA services (such as billing and collecting premium); and certain services provided in accordance with the federal Health Insurance Portability and Accountability Act.
Services which will run afoul of the anti-rebating and inducement are those too attenuated to the provision of insurance, or otherwise not specified in the policy and if provided for free, or at a reduced fee are listed, as follows; flexible spending administration and legal services; payroll services; referrals to third-party service providers through which an insured may receive a discounted rate; advice regarding compliance with federal and state laws concerning human resources; management of employee benefit programs; preparation of employee benefit statements listing all of the benefits provided to employees that are unrelated to the insurance purchased; development of employee handbooks and training, which are unrelated to the insurance purchased; services related to employee compensation, discipline, job descriptions, leaves of absence, organizational development, business policies and practices, safety, staffing, and recruiting that are unrelated to the insurance purchased.
CL-9 also discusses that a new law signed last year by Governor Paterson expressly excludes the provision of a wellness program from the anti-rebating and inducement prohibitions provided that the program is specified in the policy or contract. CL-9 concludes with a caveat that the lists described above are not exclusive, and are listed only for illustrative purposes. As I read the lists of “do’s and don’ts of rebating and inducements, I cannot help but to think that the time has come for a new approach to this very old issue. Producers today are offering a myriad of services that the agents and brokers of yesteryear never even dreamed about. Modern agencies and brokerages can be large institutions with many varied and knowledgeable insurance, financial and administrative professionals that exist to provide services to insureds. It somehow does not seem right to prevent the provision of these services on a “no-cost” basis. I have always hated to see the rebating and inducement rules used to deny benefits to consumers.
Rebating and Inducement laws find their origin in the early part of the 20th century. The Armstrong commission found that “rebate statutes were necessary to protect the consumer from bribes, kickbacks and ruinous competition.” I know these protections have worked, for the most part, for over one hundred years. However, given our modern regulatory tools, I’m sure we have other, better ways to guard against the practices cited by the Armstrong Commission.
I have also seen that the argument in favor of repealing the rebating statutes cites that consumers will benefit if left to negotiate producer compensation and other producer services.
While I don’t seek to deal with that argument in this forum, I would believe that for commercial coverages this may be true. I, instead approach the issue from the standpoint of consumer benefit from the services offered by producers without charge. When the law instructs producers not to offer certain payroll or management services to clients when that client is not being charged for those services, the law actually hurts the consumer it was designed to protect.
Consequently, I do not argue for repeal of the rebating and inducement laws, I recommend that they be rewritten to allow for such “free” services, which would enable consumers to take advantage of them, without foregoing some of the important protections traditionally afforded by those laws. I am aware that smaller producers do not have the in-house resources to provide the services listed in CL-9 for no charge as do larger agencies and brokerages. However, the answer for those producers and the insurance department is to find a way to create the environment in which they are able to offer the services instead of preventing all players in the market from offering them.
Senior officials at the Department have discussed a change in the rebating and inducement laws in the recent past. Perhaps, now, a critical mass has developed to provide the energy to take a complete and fresh look at one of the Armstrong Commissions most sacred recommendations.
New York Legislature to Penalize Captives in an Attempt to Close Budget Gap
In a subject that is near and dear to my heart, the proposed New York State Budget, which may be enacted by early April, contains provisions which will have a chilling effect on New York’s captive insurance industry.
Since 1997, New York has had the view that domestically domiciled captives are not subject to regular insurance taxation (except premium taxes) and not includible in a combined New York State income tax return. This will change if the Budget Bill S. 60/A.160 passes. The Bill adds into law a new definition – “overcapitalized captive insurance company” – and for those captives that fit the new definition, traditional income taxation rules will apply.
Currently, a captive insurer is exempt from New York State Income tax in recognition that it functions as and is, indeed, an insurance company. Under such rules, New York has fostered a modest number of domestic captive insurance companies. The purpose behind the enactment of the captive law in 1997 was to provide New York businesses with an option to form and operate a captive insurer here in New York, along with its other corporate operations. This proved attractive for many New York companies. Captive growth in this state has been curtailed in large part due to the rather restrictive financial threshold required to form a captive insurer here. A parent corporation must have and maintain a net worth of at least one hundred million dollars to have the right to form a captive. What other state domiciles had in numbers, the sheer size of the captives domiciled in New York made the state a significant domicile, nationally. As a result, New York benefitted from payment of the premium tax and other positive economic impacts from the program.
The progress that has been made in the past twelve years may be lost if the tax treatment of these captives is changed. An “overcapitalized captive insurance company” is defined in the budget as a corporation or association taxed as a corporation for Federal income tax purposes and “licensed as a captive insurance company under the laws of this (NY) state or another jurisdiction” and “whose business includes providing, directly and indirectly, insurance or reinsurance covering the risks of its parent and/or members of its affiliated group” and ‘’fifty percent or less of whose gross receipts for the taxable year consist of premium.” In other words, if a captive finds more than 50% of its income from investments or other sources instead of premium, the captive becomes subject to inclusion into the parent’s combined return and income tax. The definition includes captives that are domiciled in other states but owned by New York Companies.
In an attempt to prevent companies from “stuffing” unnecessary assets into the captive in an effort to avoid income tax on those assets, New York is jeopardizing the entire domestic captive industry. Since the designation of an “overcapitalized captive” occurs at the end of each year, it becomes impossible to plan a captive strategy if a company will not know until the end of the year whether or not it must include the captive in its consolidated return. This will be a disincentive to site a captive here in New York. Instead of evaluating the asset strategy of each captive to prevent “stuffing”, the budget approach is essentially a sledgehammer being used to kill a flea.
I understand that our difficult economic times call for increase revenue but there is no need to kill a young and promising growth industry that could benefit all New Yorkers in the future. There must be a better way to resolve the problem and I know if the Tax and Insurance departments sat down together and worked on it, a better solution could be found. Let’s hope that happens.
