that was one of the reasons why insurance companies did relatively well, but a period of terrific inflation that we might very well have in this country-many economists fear that-would put the insurance companies in great difficulty.

The reason I bring this up is because

Senator BROOKE. It would really affect life.

The CHAIRMAN. It would affect life even worse, but it would affect any product liability, for example.

Mr. JONES. That was part of GEICO. If you go back, they had to make very substantial increases in reserves because of the cost of repairing automobiles in the fourth quarter of 1 year. It was inflation in their obligations of cases pending that threw them suddenly into a very perilous position.

The CHAIRMAN. The reason I raised this problem is because you, Mr. Maisonpierre, said you fear that establishment of a Federal guaranty fund would weaken the State guaranty system by leaving the States with only the weakest companies.

There is some merit in that argument. But other witnesses have argued the insolvency protection should better be afforded at the Federal level, since insurance companies are so big and so widespread that if you really have a serious inflationary development, for example, that many States wouldn't have the reserves, the funds to provide the protection in another series of GEICO's, where as the Federal Government with a national system backing it up would be in a position to provide this.

Mr. MAISONPIERRE. Mr. Chairman, I would agree with you 100 percent, that inflation is extremely detrimental to insurance, particularly property and casualty insurance. To the extent that we have open competition, the companies can charge the rates which they believe are commensurate with the risks being insured, then they can feed into the rate structure some trends, some factors, to take care of future inflationary costs.

it?

The CHAIRMAN. But that takes a while to cure your problem, doesn't

Mr. MAISONPIERRE. No; in the costing of insurance, you never cost your product to recoup for past losses. You always cost your product in the anticipation of what the losses are going to be.

The CHAIRMAN. I agree with that. I think that is right, in the long run there is no question that you can come out if you anticipate what kind of inflation you are facing. But if you can't do that, and we don't know what the inflation rate will be-if there is anything the economists have fallen flat on their faces on it is predicting inflation. In 1974 the Council of Economic Advisers was saying it would be 2 percent at the end of the year, and it was 12 percent. It is hard to predict this.

If we are hit with inflation, and we can't anticipate it, then it would seem to me we might have a serious crisis in the insurance industry. Mr. MAISONPIERRE. We have lived with inflation. We have had inflation. The insurance industry is learning to cope with inflation. I think one of the problems we have today with product liability for instance is that the industry has suddenly realized it is going to be paying losses many years after having collected the premium, and

that the dollar which it will have to use to pay those losses is, the dollar being collected in premiums, will have devalued considerably. Accordingly, the industry has fed into its rating system some factors to compensate for this future loss.

The consumers, the buying public, doesn't recognize there have been some changes in the concept of insurance pricing, recognizing the fact that insurance has to consider future social as well as monetary inflation, and both are very important.

if

The CHAIRMAN. I understand your response, I think it is the best response you could give under the circumstances. But I still argue that you can't predict it, and we might have a high rate of inflation that you aren't going to have built into your structure. If you do build it into your premiums, that kind of inflation, and we don't get it, then you will have windfall profits that you would have a lot of complaints about, too.

Mr. MAISONPIERRE. That is right. This is the reason I believe that whatever is built into the rate structure today to account for inflation could still prove to be somewhat inadequate.

Mr. MERTZ. Senator, one point on that, a small point.

I think that the experience that the industry went through in 1974 and 1975, which was a combination of rampant inflation on the one hand, and a tremendous drop in the securities market, which are not supposed to happen together, was probably the worst set of circumstances not the very worst, but almost the worst set of circumstances you can imagine for our business. It was, I might add, unprecedented. And it almost you might say approached the impact of the Great Depression on banks, but not quite so much.

The CHAIRMAN. If it had gone on a while longer, and been a greater inflation, you might have had some very serious difficulties in the insurance industry.

Mr. MERTZ. Indeed, if it had gone on long enough, nothing would have saved it.

But it is important to note our industry weathered that storm. The CHAIRMAN. That is a good answer. I would like to ask one more question of Mr. Jones.

You say the pattern of State regulation of insurance companies lacks uniformity, and is disappointing, but you oppose Federal regulation, you say that the State regulation could be much improved if more attention were paid to the interstate nature of the insurance business. Mr. JONES. Right.

The CHAIRMAN. Why wouldn't it be possible, as Senator Brooke argues, that Federal regulation might improve State regulation? It might set a standard, provide a basis for improvement, greater expertise, greater professionalization of your technicians on whom you rely.

The case has been made, and not challenged at all, by a previous witness that the regulators are paid relatively little, and you can't get more competent people in the regulating industry. So why wouldn't it be likely if you established the kind of apparatus that Senator Brooke proposes, the whole process of regulation would be improved?

Mr. JONES. That is a possibility. There have also been questions raised recently about the level of competence in Federal as well as State regulators.

We urged that the committee give further consideration and study to the concept of a truly optional system. We have a number of reasons for that. Some companies are interstate national insurance companies. Yet we readily recognize, Senator, that there are companies that would have no reason whatsoever to be involved with a Federal regulatory system.

There are 3,300 property casualty insurance companies in the country. A. M. Best Co. keeps track of 1,850. There are a lot of fine reliable local mutual fire insurance companies around the country. You can drive through upstate New York and find New Berlin Mutual Fire Insurance Co. They insure property losses in their area, and are very difficult to compete against, because they have low operating costs. The concept should be explored more. If I could go back to one of your statements-something may happen right after this testimonywe do think that our industry has a very fine record of performance in the financial community. Relatively speaking, we have had fewer scandals than might be in other industries. We have experienced Equity Funding and others, but we think there is a fine record in this industry, and that was the reason we were concerned about the extent of regulation Senator Brooke seemed to feel was necessary in S. 1710. I think that is what needs to be reviewed and reevaluated. The CHAIRMAN. Thank you. Senator Brooke.

Senator BROOKE. I have no further questions. I again want to thank this panel, I think they have really contributed. I think it is going to be an excellent record.

The CHAIRMAN. It has been a very, very good panel. Thank you, gentlemen, very much.

The committee will recess until 9:30 tomorrow morning.

[Thereupon, at 12:50 p.m. the hearing was recessed, to reconvene at 9:30 a.m. the following day.]

[The following letter was received for the record:]

Hon. EDWARD W. BROOKE,
Russell Office Building, U.S. Senate,
Washington, D.C.

AMERICAN INSURANCE ASSOCIATION,
Washington, D.C., October 19, 1977.

DEAR SENATOR BROOKE: As a supplement to the testimony of our President T. Lawrence Jones before the Committee on Banking, Housing & Urban Affairs September 13, 1977, we submit the following comments on the investment and tax provisions of S. 1710 for your consideration. We approach this bill with your admonition in mind that it is a working document to be studied and criticized. The preamble to the Federal Insurance Act states:

"The United States national policy shall be to facilitate early detection of the financial condition of insurers which, if not corrected, render reasonably probable the insolvency, impairment or inability of such insurers to fulfill their contractual obligations to policyholders or claimants when due, and to provide for the orderly winding down and liquidation of insolvent insurers by establishing a Federal insurance guaranty program which shall establish uniform standards for guaranty status and shall maximize the efficient utilization of the capabilities and facilities of private insurers in the discharge of policy obligations of private insurers in the discharge of policy obligations of private insurers which become insolvent [§ 102(a)].”

Assuming one could accept this premise, over which the hearings produced substantial disagreement, it is difficult to understand why the pervasive scheme of investment regulation in S. 1710 is necessary, or why the subject of retaliatory state taxation for property-casualty insurers is relevant or material.

In the case of a Federally chartered insurer, the Federal Insurance Commission would be given power to disallow any investment which supports policyholder obligations and minimum capital and surplus if it fails to meet the standard of "integrity and stability." This standard has no precedent, except in a recent amendment to South Carolina law. The Federal Insurance Commission would be free to interpret its meaning much in the same way as the Federal Trade Commission (FTC) decides what is an “unfair trade practice." The fact the standard in S. 1710 has little relationship to previous regulation of insurance investments at the state level may give the new Commission wider latitude than FTC enjoys.

Even though the bill is presented as an option, which theoretically would allow insurers to remain regulated by the states, S.1710 would bring to bear a powerful Federal presence on the way investments are regulated at the state level for any company which wishes Federal guaranty protection without a Federal charter. In evaluating applicants for a Federal guaranty certificate, the Commission is directed to "make such examination ... as it deems necessary to ascertain ... [its] financial condition and fitness. For this purpose, the Commission may utilize [its] employees . . ., independent contractors, and other agencies of the Federal Government. It may take into consideration reports of independent auditors and reports and certifications by State supervisory authorities [§ 103 (d)]. The bill repeats a provision from S.3884: "Any person exercising or possessing effective control of a federally guaranteed insurer shall be subject to the regulatory authority of the Commission" [§103 (e)].

The Commission may refuse to issue a certificate upon determining an insurer "is not financially safe and sound for any, or any combination of . . . reasons," the first of which being "assets supportive of the insurer's policyholder obligations fail to provide sufficient integrity and stability for that purpose" [§103 (h) (1) (B) (1)].

Investments of a federally guaranteed insurer, other than a federally chartered insurer, shall be regulated, in general, by the laws and regulations of ... [the] State of domicile and... States in which it transacts insurance unless the Commission shall determine, after hearing, that the laws or regulations of such State or States fail to require that the minimum policyholders' surplus and reserve liabilities, including the loss reserves, unearned premium reserve, and mortality and morbidity reserve . . . be covered, to a reasonable degree, by admissible assets of sufficient integrity and stability. . . Upon making such findings, the Commission shall issue such order as is necessary to bring the insurer's investments into compliance . . . or to terminate it status as a federally guaranteed insurer ... The Commission is authorized to issue a subpena requiring the insolvent insurer to furnish such books, records, or other materials [§103 (j)]. The degree of control which the Commission would possess over non-chartered federally guaranteed insurers may be more strict, even though indirect, than the direct control it would possess over federally chartered insurers. In non-chartered companies, minimum policyholders' surplus and reserve liabilities must be covered by admitted assets, to a reasonable degree, "of sufficient integrity and stability." There is no basket of 30% policyholders surplus cut into this requirement, For Federally chartered insurers, only policyholders obligations plus minimum capital and surplus must be covered by assets of intergrity and stability. The full implications of this distinction are difficult to weigh.

The philosophy underlying the pervasive regulation of invested assets in S.1710 appears to assume an insurer must be able to pay all of its policyholders obligations simultaneously, or within a very short span. Insolvencies do not occur in this manner. Outstanding obligations mature in the regular course of business. Insurers collect policyholder funds in advance for distribution in claims at a later date. As long as an insurer enjoys a positive cash flow it will be able to meet policyholder obligations even though the value of liabilities at a given time may exceed the value of assets. We believe the attempt in S.1710 to limit investment risks rigidly by law would accelerate the danger of insolvency by removing management's ability to relate investments to different risks associated with the varying mix of business written by each insurance company, and to respond rapidly to changing conditions in our complex economy. Containing investment risk alone is meaningless in protecting policyholders adequately against insolvency. Underwriting risk must also be considered. No more than one percent of recent insolvencies may be attributed to investment losses. The predominant causes of insurance insolvencies have been underwriting losses and dishonest management. A more relevant means of accomplishing

the national policy enunciated in S.1710 would be to establish an effective early warning system which operates under the concept of "multivariate discriminant analysis." We are currently discussing the desirability of an early warning system geared to "multivariate discriminant analysis" with the National Association of Insurance Commissioners (NAIC).

Section 204 (b) of S.1710 states:

"Nothing in this section may be constructed to deny to any State the right to levy taxes or to require license fees for federally chartered insurers. . . except that a federally chartered insurer has no liability to any State for a tax measured by gross premiums or net premiums collected to the extent that the amount . . . exceeds . . . the amount which would be imposed on the same amount of gross or net premiums of the least taxed insurer . . . doing the same type of business and organized under the laws of any State. . . . Except as otherwise provided herein, a federally chartered insurer shall for tax purposes be taxed at no higher rate than a foreign insurer doing the same type of business in any State in which it is authorized to do business."

We have explored carefully the way in which section 204 (b) would impact state taxation of property-casualty insurers, and have discovered little, if any, benefit. Clearly it would not eliminate all retaliatory state taxes. Many retaliatory taxes are not measured by premiums. A State could continue under S. 1710 to charge domestic insurers a higher or lower rate of taxation than would be charged federally chartered insurers operating in the same State. States would also be able to continue offering domestic insurers lower tax rates than foreign insurers which compete in the domestic insurer's home state. Because the effect of section 204 (b) is equivocal, it might cause States to raise the rate of taxation on all property-casualty insurers to compensate for expected revenue losses, without offering any appreciable relief to insurance companies. On baalnce, our members believe the existing State system of taxation is working. We are apprehensive that an attempt in S. 1710 to explore this subject may cause States to increase the level of taxation. The fear by the States of losing revenue from taxation of insurance companies as a result of the Southeast Underwriters decision was the principal reason Congress enacted the McCarran-Ferguson Act. Section 204(b), taken in context with other provisions in S. 1710, raises obliquely many questions about the current taxation of insurers under the Internal Revenue Code. This would almost certainly invoke the jurisdiction of the Senate Finance Committee and the House Ways and Means Committee. We respectfully suggest section 204(b) is not relevant or material to the fundamental objectives of S. 1710, and should be deleted. We firmly believe the Federal Insurance Act should take no action, directly or indirectly, which would affect the existing method of taxing property-casualty insurers at the State level, or under the Internal Revenue

Code.

Our more specific concerns regarding S. 1710 are stated below:

1. No distinction is made between life, health or property-casualty insurance. Investments by all insurance companies would be regulated in common by Section 205 of S. 1710. Traditional distinctions between the appropriateness of various categories of investments for different insurance functions are ignored generally. The evolutionary way these distinctions have developed at the state level is disregarded. Limited recognition of the need for such distinctions may be found in subsection 205 (c) (12), (13) and (14) which permit life companies to invest assets supporting policyholder obligations in loans to policyholders who pledge their policy as collateral, and in bonds or notes secured by certain classes of real property, or insured by the U.S. Government.

The tendency to look upon life, health and property-casualty insurance as one industry which should be regulated in the same manner appears also in the approach towards issuing a Federal charter :

"In the case of a group or fleet of insurers under common management or subject to the effective control of one person, including, but not limited to, a holding company, no one or more of such insurers (other than alien insurers) constituting such group or fleet of insurers or insurers under common management or control shall be chartered unless all be so chartered or a plan for such chartering is filed with the Commission for its approval [203 (a) (3)].”

It is difficult to understand why all life/health companies under common control or management, or all property-casualty companies under common control or management would not be eligible for a Federal charter regardless of whether other types of insurance companies under the same management or control are chartered at the Federal level.