Draft Version: Please do not cite without permission
Federalism and Insurance Regulation
Prepared for the Federalist Society’s Annual Lawyers Convention,
panel on insurance regulation, November 15, 2001
I do not actually know
anything about financial markets and regulation, Peter Wallison and my
distinguished fellow-panelists graciously acceded to my request for a
conceptual assignment, rather than a policy-reform talk.
will argue that there is no necessary
conflict between federalism and efficient insurance regulation; it all
depends on what kind of federalism. I will distinguish a bad,
states’ rights federalism, which does present such a conflict, from
a good, competitive federalism, which does not. I have tried to
develop that distinction and argument in other contexts. With my
trusted federalism hammer in hand, the forebodingly complex and
confusing subject matter looks like just another nail. Having hit my
nail one more time, I will make a concession to the topic at hand and
argue that proposals for an optional federal insurance charter are in
principle consistent with competitive federalism, though not a
necessary part of it. Finally, I’ll argue that Gramm-Leach-Bliley
may represent a step towards, and an opening for, competitive
federalism—or the opposite.
means that states will attempt to protect and favor their own
citizens and companies vis-a-vis outsiders. Bad, states rights
federalism lets them get away with it. First, bad federalism allows
states enact statutes that discriminate against outsiders, openly or
covertly. Second, bad federalism rests on a “destination”
principle: in interstate transactions, it is the law of the
customer’s or buyer’s state, not the law of the producer or
seller, that governs the transaction. This means that
companies—regardless of their domicile—must comply with the rules
and regulations in each of the fifty states where they do business.
by and large, is the “federalism” that we have in insurance,
except that it’s worse. Obviously, it is incompatible with a common
market; in fact, it is a regulatory balkans. For the dangers and
disadvantages of a regulatory balkans, see the actual Balkans.
rights federalism, however, is not the only possible federalism (and
wholesale nationalization is not the only alternative to bad
decentralized regulation). Also possible, and much closer to the
Founders’ vision, is a competitive federalism. Instead of
facilitating parochial protectionism, competitive federalism
integrates markets and compels states to compete for citizens’ and
federalism’s structural principles must be supplied either by the
federal Constitution or through federal law. Let me mention four such
principles and contrast them with current practice:
States must be barred from enacting laws that discriminate
against outside parties. To the Founders’ minds, this command
constituted a principal protection against state protectionism and
impositions on a common market. It is expressed in a half-dozen
constitutional provisions, from the Privileges and Immunities Clause
to the Export-Import Clause and the Full Faith and Credit Clause. The
“dormant” Commerce Clause has also come to be understood as an
injunction against (facially) discriminatory state statutes that are
not specifically authorized by Congress.
glitch with a constitutional anti-discrimination principle is that it
captures only blatantly discriminatory state laws, not the states’
countless “evasive maneuvers” (Madison) to disguise
discrimination. That is why the Commerce Clause authorizes Congress to
legislate against state discrimination and protectionism. In the
insurance markets, however, Congress has failed to exercise this
option and, in fact, done exactly the opposite: under the “reverse
preemption” logic of the McCarran-Ferguson Act, blatantly
discriminatory and protectionist state laws that would otherwise
violate the dormant Commerce Clause are rendered lawful (subject only
to very weak equal protection constraints).
Competitive federalism requires free exit. Citizens and
companies must be able to vote with their feet and their
pocketbooks—companies, by choosing their domiciles and the places
where they do business; citizens, by choosing products that, under
competitive federalism, come along with the legal rules of the
product’s or service’s origin state. The bedrock principle of
American federalism is that citizens choose their state.
bedrock principle of insurance regulation is the reverse: no exit. A
California citizen is stuck with California’s consumer protections,
whether he wants them (on the books and in the product price) or not.
Corporate changes of domicile are virtually unknown, both on account
of regulatory obstacles and because threats of state retaliation
appear to be widespread or at least widely feared by insurance
companies that have contemplated redomestication. Several states even
administer exit restrictions that preclude states from discontinuing
product lines that have been rendered unprofitable by state
regulation. We might as well legalize confiscation.
Competitive federalism requires reciprocity, meaning that each state
will respect and enforce the legal rights (charters, licenses, and so
forth) obtained in another state. Under this “origin principle”
(or “principle of mutual recognition,” as it is called in the
European Union), each company need comply with only one set of legal
rules—those of its domicile state. Insurance regulation operates on
the opposite principle: the customer’s law governs. That is an
annoyance in personal lines, where agents sell policies in one or two
states; it is a much, much bigger deal in commercial lines, where the
producers’ compliance obligations in multiple jurisdictions drive
expense ratios (of cost to premiums) through the roof.
of Law and Federal Courts. Competition among governments
requires that citizens and companies must be able to rely on the
application of the law of the state that they have chosen, either by
domiciling in that state or by contractual choice-of-law and
choice-of-forum clauses. Put bluntly, market participants need
protection against state attorneys general and trial lawyers who will
attempt to “home cook” out-of-state insurers in front of a home
state jury and judge of their own choosing. Realistically, this
requires a federal choice-of-law default rule designating the domicile
state’s law as governing multistate transactions; uncompromising
enforcement of contractual choice-of-law and forum clauses; and access
to federal courts in all cases of minimum diversity. None of these
conditions exist in the insurance markets.
chartering in the United States provides an actual example of
competitive federalism in operation: companies freely choose their
state charter, which will then govern its legal relations with
shareholders everywhere. In principle, this Delaware model can be
applied to insurance regulation; the difficulty, I think, (apart from
building sufficient political support) lies in specifying the
appropriate range of its application.
requirements would appear an obvious candidate for competitive state
arrangements: much like big, well-informed institutional investors
induce corporations to choose state charters that maximize shareholder
value (in contrast to entrenching management), so profit-maximizing
financial institutions would presumably choose states with optimal
(rather than excessively lenient) solvency
requirements and arrangements.
and registration requirements are likewise plausible candidates, and
full reciprocity in this area would eliminate the compelling
complaints over the existing, protectionist system and its inordinate
compliance costs. Full reciprocity for new products would solve
speed-to-market issues and facilitate more efficient competition
these areas, the competitive, mutual recognition principle threatens
to undermine state consumer protection statutes and the rationales on
which they are based (such as consumers’ difficulty in understanding
very complicated financial instruments). But concerns over adhesion,
asymmetric information, and unequal bargaining power do not apply in
the area of commercial lines, where bargaining parity prevails and
marginal purchasers can be presumed to be reasonably informed. Thus,
the case for full reciprocity and state competition seems most
plausible in precisely the area where those principles would do the
hypothetical federal insurance reform that would mandate
non-discrimination, free exit, full reciprocity, and access to an
impartial forum in multi-state conflicts would be fully federalist: it
would not materially, substantively regulate the business of insurance
at all. States, not the federal government, would continue to do so.
In contrast to states-rights federalism, however, competitive
federalism poses no conflict with open markets and efficiency
concerns. Reciprocity ensures that no company is subject to more than
one set of regulations; exit and non-discrimination ensure that
companies may operate, and citizens may choose, everywhere.
Differences between the state regimes aren’t politically
“harmonized”; they are arbitraged through consumer and producer
such a reform might be more efficient than a uniform, substantive
federal reform. We are very unlikely to find efficient regulation by
drawing it on a piece of paper, and any mistake we make at the
national level will by definition be a very big, nation-wide mistake.
Actual state experimentation is a better bet—again, under
suitably defined, competitive conditions, as distinct from a
protectionist “states’ rights” regime that treats private market
participants as guinea pigs. That is so especially since the federal
government is less disciplined by the threat of market exit, and
therefore more prone to interest group racketeering and wealth
transfers in the name of “reform,” than are states that operate
under competitive conditions.
competitive federalist will often despair of the political
viability of his position. Competitive federalism substitutes private
arbitrage for political harmonization and thus wrings the rents out of
the system, which means that no one with a say on the
matter—interests, advocates, regulators at every level—want any
part of it. In the insurance context, however, the much-discussed
option of an optional federal charter may provide an opening.
optional federal charter follows the logic of competitive federalism:
it offers producers and, therefore, consumers a choice between
competing legal regimes (and may the best regime win)—except that
the choice takes place along a vertical rather than horizontal
dimension, and that only two rather than fifty choices are being
offered. Thus, no serious federalist should reject the proposal as
unduly “nationalist”: it is not, at least not in principle. I
would only caution that the devil lies in the details. I suspect that
it might be hard to mimic the principles of horizontal competition
among equals—non-discrimination, free exit (both ways), full
reciprocity, and a reliable, impartial forum—in competition between
two inherently unequal partners. On the one hand, the federal charters
must not be allowed to disintegrate into a kind of federal “floor”
of minimum standards, over and above which states may still regulate;
they must be a clean, unimpeded choice. Such unequivocal preemptions
are extremely rare in federal law, and they may be especially hard to
come by in the insurance setting. On the other hand, effective
vertical competition requires some credible assurance that the senior
federal partner will in fact tolerate, over time, the competition it
has just established. But while these difficulties may prove
considerable or even intractable, they do not constitute an objection
on federalism grounds.
optional federal chartering follows competitive federalism’s general
logic, it is fully consistent with that system. Under a fully
competitive state regime, the additional option of a federal charter
would simply transform the federal government into the 51st
state. Obviously, that option is not strictly necessary: state
competition, theoretically, does all the work that an optional federal
charter is meant to do. There may be good reasons for providing that
option even under a fully competitive regime, and there may be good
arguments against it. But again, these considerations have to do with
policy, not with federalism.
give credit where some small measure of credit is due, the
potential attraction of reciprocity has not entirely escaped federal
legislatures. Title III of the Gramm-Leach-Bliley Act prods the states
towards mutual recognition of insurance licenses.
Should a sufficient number of states fail to achieve that objective by
November 2002, GLB threatens the establishment of a supra-state
agency, under the supervision of the NAIC and, failing that, directly
under the federal government, to bring about the statutory objectives.
That is a step towards a more competitive environment—but it is a
small step and, moreover, the sort of small step that may make matters
problem is not so much that the statute exempts some of the most
odious, protectionist restrictions (notably, countersignature
requirements), nor that it does not encompass all states, nor even
that states have appeared to make little progress. The central
problem, rather, is that federal legislators, state regulators, and
certainly the NAIC as a collective body appear to view reciprocity as
a first step towards “harmonization.” As suggested, however, the
two principles are polar opposites, and mutually exclusive means of
market integration. Reciprocity works through private arbitrage;
“harmonization,” through political negotiation. Reciprocity means
decentralization; harmonization means a single, uniform, central rule.
Reciprocity implies jurisdictional competition; harmonization, a
policy cartel that suppresses competition.
entrusts the administration of that cartel to the NAIC and perhaps a
future NARAB, rather than an actual federal agency. That concession to
states’ rights, however, exacts a heavy price in terms of political
accountability and transparency. The NAIC’s principal harmonization
vehicle, for example, is a “Producer Licensing Model Act.” It can
be obtained from the NAIC—at the modest price of $650. Not exactly a
bargain for the ordinary citizens for whose protection these markets
are ostensibly regulated.
thus threatens to exemplify a depressing scenario that is being played
out in a growing number of policy areas, from e-taxation to nuclear
waste management. Some states can move on their own towards reciprocity, but that
doesn’t help very much so long as California insists on being
California. In other words, the states can’t on their own overcome
free-rider and hold-out problems, meaning that balkanization persists.
Congress recognizes as much. But instead of trumping the
states’-rights regime with federal rules, it pays ostensible
deference to state autonomy and “federalism” and nudges, bullies,
or bludgeons the states into “harmonizing” cartels and compacts,
under the authority of a supra-state authority that is off the
constitutional charts, that is accountable to no one, and that no one
outside the regulated industries has ever heard of. NARAB was
certainly news to me
cleaner, competitive solution would be to build on the GLB reciprocity
provisions—to make them mandatory rather than hortatory; to cover
all states and all licensing requirements; to cover at least
commercial product lines; to add federal prohibitions against
discriminatory and “no-exit” provisions at the state level; to
relieve the NAIC of its harmonizing obligations; and to put the
envisioned NARAB out of its misery before a federal court strikes it
down as an extra-constitutional abomination.
Against my better instincts and initial disclaimers, I seem to have ended up with what looks like an actual reform proposal. Instead of actually defending it, let me end on a more modest, but hopefully helpful note: there is a real, competitive federalism that is fully consistent with the Founders’ dual commitment to decentralization and to a common market. But the federalism we actually have in insurance isn’t federalism; it is its parochial, evil twin. There are lots of reasons to be cautious with federal interventions in financial markets, and lots of ways to get confused about it. But the last thing that should deter or confuse reformers are false appeals to a false federalism.
 See Prudential
Insurance Co. v. Benjamin, 328 U.S. 408 (1946); Metropolitan
Life Ins. Co. v. Ward, 470 U.S. 869 (1985) (equal protection
 See generally Peter Wallison, ed., Optional Federal Chartering. And Regulation of Insurance Companies, (AEI, 2000); and, on exit restrictions, Richard A. Epstein, “Exit Rights Under Federalism,” Law & Contemp. Probs (1992).
 The redomestication provisions of the statute also embody an element of competitive federalism. The provisions, however, appear not to have been used, and I will ignore them for the purposes at hand.
The experts in this room are of course aware of the NAIC and its
activities. Many of you, however, are also governed by the Ozone
Transport Commission and soon, if the states’ rights apostles in
Congress have their way, by a Simplified Sales Tax Project.
Familiarity with one supra-state agency in nowhere land, or even
an ability to do deals with it, provides no reason for complacency
about the broader trend.