National Association of Mutual Insurance Companies

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Posted on March 28, 2005

Mutual Insurers Resist Sarbanes-Oxley-Like Mandate

By Roger H. Schmelzer

For more than a year, the National Association of Mutual Insurance Companies has contended that efforts by insurance regulators to transfer elements of the federal Sarbanes-Oxley law to insurance solvency regulation are misguided. Working doggedly to fit a square peg into a round hole, solvency regulators have greeted our pleas with a collective shrug of indifference.

But the dynamic changed in early March. That’s when the executive committee of the National Conference of Insurance Legislators unanimously directed its president, Texas Representative Craig Eiland, D-Galveston, to write a letter to the National Association of Insurance Commissioners opposing the initiative on both substantive and procedural grounds.

Applying rules to non-public insurance companies that were designed by Congress to protect public company shareholders will benefit no one, the letter declares.

If adopted, the proposal’s main effect would be to add a costly and unnecessary layer of regulation on companies whose financial reporting procedures are already extensively regulated by state solvency laws. The letter correctly notes that the cost of this additional regulatory burden "ultimately will be passed on to policyholders."

As if the substance were not bad enough, the letter strongly suggests that the means by which the proposal would become law—automatic incorporation into state law without consideration by state legislatures—is essentially illegitimate.

NCOIL has taken the right position. Sarbanes-Oxley is structured largely as a series of amendments to the Securities Exchange Act of 1934. It is intended to enhance the integrity of financial data that publicly-traded companies must file with the Securities and Exchange Commission and on which investors must rely.

The authors of the Sarbanes-Oxley law expressly declined to apply its provisions to any privately-held companies, presumably because the investor-oriented safeguards it provides have no relevance to companies that lack investors.

Sarbanes-Oxley was never intended as a tool for enhancing insurer solvency. Insurers are already subject to financial reviews to ensure solvency, and their financial reporting is periodically reviewed to ensure accuracy.

When asked why existing solvency regulation is insufficient, regulators respond that the financial reports they receive are "only as good as the numbers." The proposal to graft Sarbanes-Oxley provisions onto existing state auditing rules is thus presented as a means of ensuring that "the numbers" reported by insurers are accurate.

However, unlike the headline-grabbing corporate accounting scandals that inspired Sarbanes-Oxley, there is no evidence that insurer financial reporting has been anything but honest and accurate.

Regulators do a good job with the tools they have. The efficacy of the current regulatory regime is reflected in the downward trend in insolvencies. Weiss Ratings reports that property-casualty insolvencies declined last year by 48 percent, and that the overall number of failures reached a five-year low. These are good numbers that should not be ignored.

The punishing compliance costs insurers would face under the proposed Sarbanes-Oxley-inspired rules is a substantial issue that regulators have casually dismissed. Never mind that an SEC study estimates the aggregate annual costs of public company implementation of the Sarbanes-Oxley Act to be around $1.24 billion (or $91,000 per company), not including the cost of the auditor’s attestation report.

In light of these findings, insurers have asked for a cost-benefit analysis of the proposed insurance version of Sarbanes-Oxley, only to be told that such a study would be unnecessary and impossible to perform.

NCOIL’s procedural objection is equally serious and has only recently begun to attract attention. Sarbanes-Oxley-like amendments to the NAIC Model Audit Rule would revise the NAIC Annual Statement Instructions. These revisions would be automatically inserted into the laws of states that incorporate the instructions into their state law by reference through either statute or regulation.

As Rep. Eiland’s letter points out, incorporation by reference has its place. Legislatures rely on the doctrine to allow qualified third parties to make uniform technical changes to state statutes. However, a legislature cannot constitutionally delegate responsibility for making substantive public policy decisions to a private body such as the NAIC.

A proposal to create entirely new corporate structures and auditing procedures clearly fits within the definition of a non-delegable legislative function.

Rep. Eiland notes that a "formidable body of case law" supports NCOIL’s position that "material public policy changes to state insurance law…should only be made by elected legislators after public discussion and debate."

Indeed, state courts have insisted on adherence to constitutionally prescribed procedures for substantive public policymaking since at least 1919, when the Kansas Supreme Court declared: "If the legislature desires to adopt a rule [of a third-party organization] as a law of this state, it should copy that rule and give it a title and an enacting clause and pass it through the Senate and the House of Representatives by a constitutional majority and give the governor a chance to approve or veto it, and then hand it over to the secretary of state for publication."

Since the Sarbanes-Oxley law was itself enacted in conformance with this constitutionally prescribed process, it stands to reason that any state-based version of the law should follow the same course.

Sarbanes-Oxley was a source of great controversy when it was introduced in 2002, and was fiercely debated in the U.S. Congress. If nothing else, the NCOIL letter demonstrates that the proposed application of Sarbanes-Oxley-like provisions to non-public insurers is no less controversial than was its federal counterpart.

As James Madison observed in the Federalist Papers, reconciling the competing views and interests that invariably clash over new regulatory proposals "forms the principal task of modern legislation, and involves…the necessary and ordinary operations of the government."

Regrettably, the NAIC-led campaign to impose an ill-conceived policy initiative through anti-democratic means comes at a time when Congress is considering legislative proposals of its own that could have the effect of pulling the plug on the state system of insurance regulation.

State regulators may unwittingly hasten their own demise by implying that the existing system of state solvency regulation is inadequate and that salvation lies in a jury-rigged version of an inapposite federal law.

Roger H. Schmelzer is senior vice president for state and regulatory affairs at the National Association of Mutual Insurance Companies in Indianapolis.

Source: NAMIC staff, originally published in National Underwriter Edition, March 25, 2005.

Posted: Monday, March 28, 2005 12:00:00 AM. Modified: Monday, March 28, 2005 3:09:20 PM.

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