State Regulation of Life Insurers: Implications for Economic Efficiency and Financial Strength Steven Pottier, CLU, Ph.D. Terry College of Business University of Georgia Athens, Georgia ARIA 2007 Quebec

Introduction Does state regulation of multi-state life insurers increase costs, reduce revenues, and reduce profits? Supporters of Optional Federal Charter (OFC) for Life Insurers argue that substantial cost savings and efficiency gains will result for insurers opting for federal oversight This study examines cost, revenue and profit efficiency measures to provide insight on potential benefits of OFC

Innovations Unit of analysis—consolidated groups (affiliated insurers) and individual unaffiliated insurers Number of regulatory jurisdictions measured at group-level  States licensed and states domiciled More extensive set of inputs and outputs than prior life insurer efficiency studies Economic significance of results

Key findings Cost efficiency scores decreases as the number of states licensed or domiciled increases, but increases with insurer size Revenue and profit efficiency scores are not affected by multiple state regulation Costs to benefits provided and revenues to benefits provided both increase with number of states licensed or domiciled, suggesting higher costs are offset or passed along to consumers

Overview of life insurer regulation Market regulation  Licensing, policy/contract provisions, rates, sales and claims practices  In general, life and annuity rates not regulated Financial regulation  Capital requirements, investment limitations, reserve requirements, and guaranty funds  Substantial compliance—deference to state of domicile

Related literature Grace and Klein (2000)  Individual life insurers, 1997  Expense ratios increase with the number of states licensed  Salary expense and license/fee expense ratios higher in restrictive regulatory environments (total expense ratio not) McShane and Cox (2006)  Individual life insurers  Expense ratio is not related to the number of states licensed or to being a single-state insurer Numerous studies using similar empirical method (i.e., I/O definitions, DEA)

Hypotheses and variables 1 Number of states licensed Number of states domiciled  Regulatory compliance costs are likely to increase when insurer group is licensed or domiciled in more states  Expansion into more states may present greater opportunity for revenue growth and consumer may place higher value on insurance from multi- state insurer  Binary variables multi-state and multi-dom also considered

Hypotheses and variables 2 Size—scale and scope economies Health insurance—financial and regulatory differences from life and annuity business Ownership form—implications for activity choices, different product characteristics, monitoring costs; used ultimate owner’s form Publicly-traded—additional regulatory requirements, capital access Multi-line—property/liability or health affiliates, scope economies or diseconomies

Hypotheses and variables 3 Line-of-business concentration—scope economies or diseconomies New-York licensed—does not recognize substantial compliance, extraterritoriality Capital/assets—relation to risk, capital costs Common stocks/invested assets—investment risk and investment expenses Group member—economies in complying with regulations, complexity of operations, broad services

Sample and data 2005 annual statement year blue-blank life insurers with positive assets, premiums and capital Data—A.M. Best and NAIC Under 50 percent of gross premiums from reinsurance assumed Single insurers—domiciled in U.S. Consolidated groups—one or more members domiciled in U.S. Tables 2 and 3—summary financials Tables 4 and 5—summary statistics Table 6—correlations Main sample contains 284 life insurance entities

Inputs and outputs—quantities and unit prices Three main services of life insurers  Risk pooling, real services and financial intermediation 11 Outputs (benefits provided customers)  Net incurred claims (5 lines)  Invested assets (5 lines) and deposit-type contracts 6 Inputs (costs)  Agent and admin labor and business services—consists of general insurance expenses, taxes, licenses and fees, commissions on direct business and reinsurance assumed  Capital—reserves, deposit-type funds, and equity Input prices—U.S. BLS, Ibbotson Associates, and crediting rate deposit funds Output prices—revenues (investment and non- investment) divided by output levels, truncated

Empirical results—main sample (284 firms) Table 7—states licensed and domiciled and size  Panel A—DEA efficiency scores  Panel B—”traditional” efficiency measures Table 8—table 7 panel A augmented by control variables Table 9—DEA cost efficiency by size quartile

Financial strength and regulation (241 firms) Table 10—summary statistics categorical variables Table 11—correlations Table 12—ratings, regulatory variables, and other controls Table 13—ratings and efficiency measures Table 14—107 insurers not profit efficient Multiple-state regulation reduces financial strength of profit inefficient insurers

Estimated cost savings of single regulator Table 15—based on parameters from table 9 Assumes that only actual costs, not optimal costs, change due to single regulator Cost savings might not all be related to regulation— inherent problem identifying what portion of costs are related to regulation and what portion is related to expansion to other states  Partly address by not including commissions that are part of inputs (costs) used to estimate regression parameters in Table 9 Reasonableness test—consider in relation to premium revenues and ACLI survey work