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

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 principal-agent 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.