Despite the spirited and well-organized defense of state regulation in recent weeks displayed by National Association of Insurance Commissioners officials, the near failure of American International Group means one certainty here in Washington–federal oversight is coming.

It is unclear whether the model will be legislation proposed in both the House and Senate to create an optional federal charter for insurers, or some umbrella federal oversight on top of the current state-based system, but Uncle Sam is coming.

According to industry lawyers who insist on remaining anonymous, several recent events give strong hints as to what's ahead.

First, in the congressional bailout package, insurance is included for the first time in the definition of “financial institutions” eligible to participate in the federal program to sell toxic mortgage-backed instruments to the government.

Meanwhile, in August legislation disguised as a bid to help homeowners, but which really turned out to be no more than a law enabling the federal takeover of Fannie Mae and Freddie Mac, there is a provision setting up a federal system to license and regulate mortgage brokers. You figure out what probably comes next.

No matter how high or coordinated the decibel level used by state regulators to reassure insurance consumers of the sanctity of their calling, it will be muted by the fact that Washington was blindsided by AIG's financial problems, and that won't be allowed to happen again.

According to a number of industry lobbyists, members of Congress were oblivious to Wall Street's fundamental problems, even after the Dow Jones Industrial Average suffered a 500-point loss. The wakeup call came from Treasury Secretary Henry Paulson on Sept. 17, less than 24 hours after AIG negotiated its $85 billion loan with the Federal Reserve.

Committing the federal government to keeping AIG afloat, then twisting arms to wring another $700 billion out of Congress to resuscitate moribund financial markets–over the objections of furious constituents–was an out-of-body experience for many clueless members of Congress, according to lobbyists and congressional staffers.

To avoid any further fiascos, a new wave of federal regulation over financial markets is coming, and insurance will not be left out.

The grim and determined mood in Washington was best captured in a Sept. 29 column by Newsweek political pundit Howard Fineman, who wrote that “the era of cowboy capitalism has died, largely of self-inflicted wounds. Who knows what's coming now? I do: A new era of tight business regulation and government intervention in the markets. For now, and perhaps for many years, there will be no going back.”

The NAIC's use of its bully pulpit to maintain pure state regulation won't sway many in Congress–not after members were pressured with threats of financial Armageddon to hand Treasury authority to take $700 billion in toxic mortgage securities off the books of illiquid financial institutions.

NAIC's boasts about the meltdown not being the fault or responsibility of state regulators also won't wash with Securities and Exchange Commission Chairman Christopher Cox, who testified before the Senate Banking Committee on Sept. 24 that Congress' failure to give any federal agency authority to regulate investment bank holding companies like AIG was a “costly mistake.”

He characterized the credit default swap market that brought AIG down as “completely lacking in transparency and completely unregulated,” calling it “another regulatory hole.” (In a case of too little, too late, CDS deals–if anyone will still write them–will be regulated by the New York Insurance Department starting on Jan. 1, 2009, but only if the actual holder of mortgage securities is involved, as opposed to those traded by speculators.)

AIG's near collapse also galvanized the attention of millions of voters with personal retirement plans, as federal officials noted that more people held AIG in their 401(k) than any other security. To reassure average people that their retirement nest eggs are relatively safe, and with both presidential candidates preaching to the choir about the need for more regulation, it's highly unlikely insurance would be spared additional federal oversight.

Eli Lehrer, a senior fellow at the Competitive Enterprise Institute, conceded that NAIC officials accurately described the reasons why AIG failed. However, he added, “no federal agency really oversaw the company in toto. Nobody, except the company's own executives, oversaw the stability of AIG's entire business. But given that most insurance companies are in a wide variety of businesses, there's little reason to think that any one entity could or should oversee all of a company's activities.”

He concluded that “NAIC's argument is a red herring,” noting that while an optional federal charter “would not put all of [AIG's] activities under one umbrella…neither does the current system.”

Expect that situation to change before too long, whether the NAIC likes it or not.

Special Reports /

AIG's Near Failure Makes Federal Regulation Likely

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