independent of the companies they were serving. Likewise, it appears that the antitrust laws would not prohibit those voluntary risk-sharing arrangements, such as insurance pools and reinsurance agreements, that were either necessary to the conduct of business or served some other legitimate business purpose without substantially lessening competition,

Based on these findings, the Report came to the tentative conclusion that an alternative scheme of regulation, without antitrust immunity, would be in the public interest. We suggested, as one possible approach, the formation of a dual regulatory system for insurance, using the federal banking system as a working model. Under such a system, insurance companies would have the option of seeking a federal charter and thereby losing McCarran Act protection, or retaining this protection under a state charter and remaining subject to the full scope of state regulation.

There are a number of provisions of the bill that are of particular importance from a competitive standpoint. These would: (1) establish a regulatory standard in favor of competition (§ 109(a)); (2) exempt federally chartered companies from state rate regulation (including regulation of risk classifications) except with respect to state residual market plans and lines of insurance raising problems of "reverse competition" (§ 204 (a) (4)); (3) exempt federally chartered companies from state solvency regulation (§§ 204 (a) (1) and (3)) and substitute a federal system of solvency regulation with emphasis on the early detection of failing companies (§ 107(b)); (4) prohibit invidious discrimination in the pricing, selection and classification of risks based, among other things, on race, age, and sex (§ 107 (c)); and require as a condition of federal chartering that all insurers under common management or control be federally chartered.

B. THE COMPETITIVE ISSUES

There are several issues relating to solvency regulation, small insurers and agents, unfair discrimination, and "reverse competition"-that we believe should be considered by this Committee in evaluating the merits of S. 1710. The findings of our study of certain major lines of property-liability insurance suggest that these issues can and should be resolved in favor of greater pricing freedom and application of the federal antitrust laws. However, these issues involve the reconciliation of important competitive and social policy questions that have not been fully explored at either the state or federal level.

I will attempt to objectively outline these issues, although admittedly I do so from the perspective of an agency that favors greater reliance on competition as the market regulator.

1. Solvency regulation

The issue of appropriate solvency regulation involves three considerations. First, solvency regulation may be used by the states as an indirect means of regulating insurance rates. Thus, in life insurance apparently the so-called “expense limitation laws," together with minimum reserve standards, minimum and maximum surplus limitations, and dividend distribution requirements, serve as an alternative to rate regulation." While these various forms of solvency regulation may be perfectly compatible with a fully competitive scheme, they must be administered in a manner consistent with competitive objectives.

Similarly, reliance on market controls to regulate prices appears to necessitate a new approach to solvency regulation as outlined by the New York Insurance Department in its 1974 report. State insurance regulators (with exceptions) have traditionally sought to "keep every insurer afloat" rather than achieve early detection of failing companies and their swift removal from the marketplace if necessary.

Finally, it should be recognized that under a fully competitive system on a national scale, inefficient insurers may be forced out of the marketplace. To avoid severe disruptions, there might be mechanisms comparable to those administered by the FDIC, in the event that the regulatory controls fail to detect a financially unsound company in time to permit an orderly dissolution.

Certain provisions of S. 1710 partially address these concerns: Section 102 (establishing a federal guaranty fund on a preassessment basis), Section 107(b)

Mayerson, "A New Look at the New York Expense Limitation Law," Society of Actuaries Transactions, Vol. VIII (1956), at 264.

New York Insurance Department Report on "Regulation of Financial Condition of Insurance Companies" (1974), at 59, 80.

(establishing an "early warning system"), and Section 109 (establishing an explicit federal standard in favor of competition).

We also think it advisable as a general principle, under any system of federal regulation in which mergers and consolidations may be "facilitated," that the agency consult with the Attorney General, so that it can properly balance competitive considerations with other policy goals. Moreover, we would caution against undue emphasis on rehabilitation and reorganization, lest federal regulation interfere with the free market mechanism as a means of removing highly inefficient insurers from the marketplace.

2. Small insurers and agents

The Department's report did not examine in depth the potential impact of unrestricted price competition on smaller insurers. Nevertheless, we are not aware of any evidence that would suggest that efficient small insurance companies would be unfairly disadvantaged under a system of dual regulation.

There is no reason to assume that smaller insurers would be unable to compete in this environment. Indeed, small aggressive.companies--seeking to expand their markets without the artificial restraints imposed by state licensing-may prefer federal chartering. Moreover, there is some suggestion that small insurers either possess or could develop independent underwriting and pricing skills. For example, in a federal antitrust framework, small insurers could have access to an independent advisory organization's trended loss cost data. Presumably, insurers specializing in certain risks-and thus exercising independent judgment in marketing and underwriting their services-would also have the ability to independently construct a rate structure, drawing on their own company's loss and expense experience and, to the extent relevant, the average experience of the bureau companies.

Moreover, we suspect that there are a number of "small" insurers that have the wherewithal to obtain outside professional advice when, in their business judgment, it is required. Independent actuarial and rate consultants can be retained by an insurer for the purpose of evaluating its own experience and the relevance of the industrywide experience. Other small insurers are part of an insurance company (or holding company) complex and may have access to professional advice from an affiliated company at a reasonable cost.

Finally, small insurers are also guided in their rate analysis by what their competitors are charging for comparable services and by the cost and availability of reinsurance, upon which small companies are particularly dependent in providing liability coverage, such as personal injury protection. We believe that competitors would be able to exchange certain price information within an antitrust framework, as outlined in our report (at pages 167-187).

In summary, we believe that the burden is upon the proponent to establish that efficient small insurers cannot operate in a fully competitive environment. Likewise, the favorable experience of smaller brokerage firms in a very competitive environment in the securities industry imposes a heavy burden upon insurance agents to establish that they would be unfairly disadvantaged under a fully competitive system. This complaint is often made, but rarely proven. It has certainly not been proven here.

3. Unfair discrimination

One of the more controversial issues raised by any proposal to substitute competitive controls for state rate regulation is the question of unfair discrimination in the sale of personal line property-liability insurance. The issue is raised both with respect to the so-called residual market, such as the state mandated automobile assigned risk plans, and the fixed commission rate structure.

The residual market issue is a complex one which we discuss at some length in our report (at pages 61-75). Essentially, the question is whether and how the mandatory plans can be regulated so as to interfere minimally with a competitively oriented voluntary market. For example, automobile insurers are generally required to participate in an assigned risk plan in proportion to their "voluntary" business in the state. If the rate charged drivers in the assigned risk plan is not self-supporting, then it must be subsidized by the voluntary market. A few state plans are operated on a self-supporting basis, but they represent the exception.

See, for example, the Fifth Report of the Securities and Exchange Commission to Congress on "The Effect of the Absence of Fixed Rates of Commissions" (May 1977), at 11.

In the past, such cross-subsidization has resulted in serious distortions in the marketplace, including discouraging insurers from increasing their market share of voluntary business. The substantial losses produced by the residual market plans, as well as a rigid rate structure in the voluntary market, have contributed to the availability problem.

We recommended in our report that federally chartered insurers be required to participate only in state residual market plans that are operating on a selfsupporting basis. We suggested that "external" state subsidies might be a feasible solution to aiding lower income drivers by providing financial assistance (either through tax relief or direct payments) on the basis of need. There may be other solutions to this "affordability" problem, but we concur with the conclusion of the Stanford Research Institute that the "public and the industry would be well served by additional research into ways of implementing transfer payments that would interfere minimally with the free market forces."5

With respect to producers' commissions, there is some concern that in a deregulated system unwary and unsophisticated consumers will not be protected against unfair discrimination, particularly where agents are free to negotiate with individual buyers as to the level of commissions and insurers are able to collectively merchandise their insurance through group plans. We believe that certain state laws have unnecessarily discouraged insurers and agents from achieving maximum efficiency in the marketing of their services. There is some indication that fixed, ungraded commission rates, supported by state rating laws against unfair discrimination and rebating, have contributed to a regressive rate structure in automobile insurance, imposing the greatest burden on the lower income drivers."

We believe that the process for determining the level of commissions-whether based on a fixed graded scale, rebating, or net pricing-should evolve from the interplay of market forces, subject only to appropriate disclosure requirements and antitrust constraints.

State restrictions on the marketing of automobile insurance (such as "fictitious group" laws) have not been the principal factors in impeding the growth of collective merchandising in the sale of automobile insurance. However, these artificial restraints appear to serve no legitimate regulatory objectives and may significantly deter future developments in the marketing of the personal lines of property-liability insurance under more favorable business conditions. We believe that insurers should be free to experiment with various forms of collective merchandising and direct writing, subject only to state regulations pertaining to the insurance contract, such as minimum coverage requirements, cancellation and renewal of policies, and policy forms.

4. Reverse competition

Section 204(a) of S. 1710 provides in part that a federally chartered insurer would not be exempt from state rate regulation in "any line of insurance (other than reinsurance) in which the Commission determines that the insurer competes principally for the producers' business rather than the business of the ultimate consumer." We understand that this provision is intended to deal with the problem of "reverse competition" which exists in title insurance and credit life and health insurance, and perhaps in life insurance generally. The problem essentially is that consumers are either "captive" buyers, uninformed buyers, or simply buyers indifferent to price variations among sellers. Consequently, insurers compete for the agents' business rather than directly for the business of the ultimate consumer, resulting in excessive commissions and prices.

In title insurance, the consumer is, in effect, captive because the service is ancillary to the principal transaction, which is the purchase of real estate. In credit health and life insurance, reverse competition stems from the inferior bargaining position or ignorance of the buyer who, again, may view the insurance service as ancillary to the principal transaction, which is the purchase of credit. I should point out, of course, that the antitrust laws as well as certain other provisions of law are designed to deter affirmative action by some

Stanford Research Institute, Final Report on "The Role of Risk Classifications in Property and Casualty Insurance...." (1976), at 4.

Id., at 97; The New York Times, November 16, 1976, at 74. Rates are regressive in the sense that drivers who pay the highest premiums (and therefore the highest commissions) are generally those with lower incomes.

insurance sellers to "capture" consumers by tying insurance to, for example, credit. In life insurance, the dependence of the insurer on the agent to initiate buyer interest in the service and the lack of consumer knowledge may contribute to excessive commissions. At least this appears to be the rationale for the "expense limitation laws" which exist in only three states-New York, Illinois, and Wisconsin-but have broad impact because of their extraterritorial application. The issue of reverse competition may require further study, particularly in life insurance, to determine the magnitude of the problem and the related question of need for state expense limitation laws, and the feasibility of permitting such problem lines to qualify for federal chartering but remain subject to selective forms of state rate regulation.

In summary, we have found a predominant segment of the property-liability insurance industry to be favorably structured for competition, with a large number of competitors, relatively moderate concentration, absence of significant economies of scale, a standardized service, a relatively simple and short-term contract, and an increasingly price-sensitive consumer market. The evidence currently available to us suggests that unrestricted price competition could be an effective alternative to state rate regulation and compatible with regulatory objectives for a reliable insurance mechanism.

The CHAIRMAN. Thank you, Mr. Sims, very much.

Your report concludes that an alternative scheme of insurance regulation without antitrust immunity would be in the public interest. You then suggest that a dual regulatory system as proposed in this bill, S. 1710, would be a good approach to that problem.

Why not just repeal the antitrust immunity for insurance companies in existing law? Wouldn't that create more competition among insurance companies and make pressures for more effective State regulation of insurance companies? As I understand it, what your proposal would do would be to repeal the antitrust exemption only for those firms that would opt to take a Federal charter.

Mr. SIMS. That's right.

The CHAIRMAN. The State regulated firms would still be exempt.

Mr. SIMS. That's right, they would still be exempt from the antitrust laws. That's a good question and I don't have a very precise answer to that. As we got more and more into the study of the insurance industry, what seemed to us at the beginning to be a relatively simple issue, that is, should we or should we not have antitrust exemption for insurance operations, became a much more complicated issue. I think the only thing that we are absolutely positive of as a result of our study is that the issue is a complicated one. Our proposal was an attempt to balance what we saw as a number of competing interests. The CHAIRMAN. What do you see as the reasons for continuing the exemption? You say it's complicated. That was the one conclusion you could come to firmly.

Mr. SIMS. Well, I guess the basic reason that we did not propose just simple elimination of the immunity is that the insurance industry itself or significant sectors of it at least-quite sincerely believe that they would not be able to undertake the kinds of ongoing operations which exist today without the existence of the exemption and that in the absence of being able to undertake those operations they could not perform the kinds of services that they perform today.

Our view, based on what we know of the industry, is that in most instances that probably is not correct, but we are not confident enough of that view across the board to come right out and say, "Remove the exemption."

We felt that the Federal chartering alternative provided a middle ground which offered significant portions of the advantages of removal of the exemption but still retained a certain regulatory mechanism in place.

Mr. MASERITZ. There's one thing I'd like to add.

The CHAIRMAN. You're the author of the study?
Mr. MASERITZ. Principal author.

The CHAIRMAN. Very good.

Mr. MASERITZ. There is one additional consideration and that is that when and if we had a proposal where the immunity was removed you would have a situation where existing antitrust exemptions with respect to State action would apply. Under the Parker v. Brown doctrine, where a State had a very active affirmative regulatory systemfor example, Texas or Massachusetts, where the rates are actually made by the State-that kind of system would be immune and presumably provide insurers with immunity from Federal antitrust laws, whereas in a State like California which has perhaps the most progressive or one of the most progressive of the competitive systems but still maintains and permits the rate bureaus, those companies and bureaus would be subject to Federal antitrust restraints.

So, on the one hand, by lifting the immunity it would subject companies that are operating in a highly competitive system to Federal antitrust laws, whereas companies that were in a very highly regulated system would be completely immune with the possible result that you might discourage the States with competitive systems from maintaining their systems and encourage much greater affirmative regulation.

The CHAIRMAN. Take a situation like Texas or Massachusetts, where you say I didn't understand this before-where you say that the State in effect determines the rates.

What kind of competitive situation do you have then if some of the big aggressive insurance firms opt to go under Federal charter, then wouldn't that create a pretty rough competitive situation? Wouldn't it be necessary for all of them to follow suit pretty much if they are going to compete? At least all in the same segment of the insurance industry.

Mr. MASERITZ. We think this would be one of the big inducements for companies to come into the Federal sphere, without antitrust exemption. That is, those remaining behind and wanting the protection of State regulation would be competing with those companies that elected to take the competitive route, and would be subject to vigorous competition on the basis of price in that State.

Mr. SIMS. Let me add one point if I may, that I think, unless we say it explicitly, sometimes gets lost in the discussion about a new system of Federal regulation.

Our firm conclusion was that the insurance industry required, in large segments of its operations, significantly less regulation than exists today. And we believe that a Federal chartering scheme of the kind we described in our report would in fact result in considerably more flexibility for companies to operate independently pursuant to competitive forces. The Federal regulatory chartering alternative in