Thursday, November 20, 2008

The AIG Mess: Insurance Commissioner Schmidt Speaks Out

I just did an article about the possible effects of the AIG bailout on AIG-Hawaii and other AIG holdings in Hawaii. It's posted at the Hawaii Independent Web site. In the process of researching the article, I had a very good interview with Hawaii State Insurance Commissioner Jeffrey P. Schmidt, who's responsible for supervising AIG Hawaii and making sure that any sale of the company doesn't go sour for its thousands of customers. Schmidt volunteered some good insights into the workings of corporations and corporate regulators in general--only some of which could be included in the 1000-word Independent article.

Among other things, Schmidt addressed one problem on which most politicians have been strangely quiet: the corporate feeding frenzy in which one company buys another until you end up with a company such as AIG, which is, in the media buzzword of the day, “too big to fail”--so the government is faced with the choice of either bailing it out or watching the entire economy tank. (It’s ironic that, back when John McCain was constantly comparing himself to Teddy Roosevelt, he didn’t bring up trust-busting. Maybe if AIG had been broken up like Standard Oil or AT&T, the risk might have been spread out a little bit.)

Schmidt mentioned the fear that the federal bailout monies would simply be used by the beneficiaries to buy up still more companies--and he questioned whether that was “a proper use of taxpayers’ money.”

Still, he noted, “In some instances, a larger, sounder company buying out a smaller troubled company is a good thing because it might protect the investors.”

Of course, I observed, it’s only a good thing if the larger company stays sound.

That launched a discussion of the benefits of large companies and small companies. Schmidt saw some value in having both types around. One role of regulators, in Schmidt's view, was to encourage this healthy mix--and make sure it didn’t go toxic: “You need to have regulations and government programs that encourage smaller entrepreneurial companies that come up with new ideas, new ways of doing things, while being closer to the consumer, while providing regulations for the larger companies that allow efficiency of operation It’s a balancing’s not a one and done kind of solution, where you implement the solution, you’re done and you walk away. The market is dynamic, and the government and regulation also have to be dynamic and have to adjust.”

The key, in his mind, was not more regulation or less regulation, but good regulation.

“An example of bad regulation in insurance,” he said, “is when the legislature decides to mandate a decrease in insurance premiums.” Such a rule, he noted, could squeeze the company’s profit margin to the point where it didn’t have enough cash in hand to pay claims.

I brought up the legislation in the 1990s that finally put an end to Hawai‘i’s notorious “no fault” auto insurance, which wasn’t truly no-fault and seemed mainly an excuse to jack up premiums.

“That’s actually a very good example of changing bad regulation to good regulation,” Schmidt remarked.

The old rules, he said, mandated that drivers carry coverage beyond the minimum needed, and Hawai‘i’s idiosyncratic insurance laws discouraged many companies from doing business in the state. The insurance reform acts passed in 1994 and 1998, he said, “changed the law to say that people simply needed to have basic coverage and if they wanted to have more insurance options, they could choose to buy it. Now, we have a very competitive auto insurance market, with lots of companies competing to provide insurance to HI’s consumers.”

In 1998, he noted, Hawai‘i had the fourth highest auto insurance premiums in the country; by 2003, those rates had dropped to 22nd.

Good state insurance regulation, he maintained, helped keep AIG Hawaii healthy while the parent company’s federally-regulate financial subsidiaries poisoned themelves on toxic investments. While AIG Hawaii had profit-and-liability-sharing agreements with other companies in AIG family, those agreements were limited by state requirements that AIG-Hawaii keep enough capital at home to cover possible claims.

Meanwhile, the parent AIG's federally (under)regulated financial service companies were buying up investments under rules that didn’t even require the buyers to know exactly what they were investing in.

“That was the main problem with credit default swaps and securitized subprime mortgages,” Schmidt contended. “People were buying these products without understanding what these products were....There was no regulatory requirement of transparency in the sale of the products--basically letting people know how it works, what the risks are.”

We didn't get into how the professional investment managers could be so stupid as to buy financial pigs in pokes, regulation or not. But I don't really think such decisions could have a rational explanation, anyway. Why do gamblers blow thousands on slot machines when they know the odds are against them?

The difference was that these folks were gambling with other people's money. But then, other people were gambling that they could make payments on exorbitant mortgages when they knew the odds were against them, too. So now the government is betting tax dollars that they can save us from our own collective greed. Is any of that rational?

All I can say about the whole situation is: good luck. And thanks, Mr. Schmidt, for playing your little role in keeping our insurance policies in effect.