12/01/2008 05:12 am ET Updated May 25, 2011

Insurers Lining Up for that Bailout Pie

The AP reports that the bailout is now "the hottest lobbying game in town." Late last week a number of insurance companies, including MetLife, The Hartford and Prudential put on their poor clothes and went begging for a little spare change. The insurers, having heard that Hank Paulson at Treasury is writing huge checks to bailout troubled banks, are pushing for government to help them get over their financial problems too. The Financial Services Roundtable has sent a letter to Treasury asking for help for the insurers in the bailout. As referenced in that letter, no help is available unless the insurer has an affiliate or subsidiary that is federally regulated. Since many don't, that is why there is a big lobbying frenzy. After all, how different could they be from AIG, the beneficiary of $125 billion in loans from the Federal Reserve?

Well, a lot different, really. AIG's downfall had nothing to do with its regulated insurance subsidiaries, which remain in generally sound financial condition. It had everything to do with unregulated "credit default swaps" that Congress said in 2000 could not be regulated as insurance. By 2008, AIG Financial Products, an unregulated subsidiary, had guaranteed billions of dollars of sub-prime mortgage debt held by banks around the world. It never bothered to reserve funds for the risk it was assuming. D'oh!

This is not what ails Prudential, et al. They are experiencing a good deal of discomfort because their reserves are invested in the securities markets where values have taken a substantial hit. But this always happens to insurers in bear markets. And when it does, they are required to raise more capital in order to maintain adequate reserves -- which could mean higher rates. If help were to come from the government, they would gain an unfair advantage over their competitors who fail to receive such help.

Other than the pronounced decline in the value of insurers' reserves, there is little resemblance of their situation to that of AIG. All states, which regulate the various insurance companies, have adopted virtually the same reserve capitalization requirements (based on a model developed by the National Association of Insurance Commissioners). These regulations limit insurers' exposure to the risk associated with individual securities and provide rules for asset diversification and risk. They are designed to prevent exactly what happened to AIG. Had its credit default swap business been regulated, AIG's over-exposure to risky sub-prime mortgage debt would probably been stopped in its tracks.

Despite regulations designed to prevent insurers inflicting financial wounds on themselves, occasionally a regulated insurer does become insolvent. In that event, the direct impact on consumers is limited by the creation of guarantee funds. I took over only two or three insurers in my days as Washington's insurance commissioner. Some were "rehabilitated" by my appointed trustees, and others were "liquidated," i.e., sold off to other carriers.

AIG is currently undergoing essentially the same process (although one could easily argue that it ought to be managed by new management rather than the same people that created the mess). It is preparing to sell off its financially sound, regulated insurance subsidiaries in order to raise the cash needed to repay the Federal Reserve.

From a consumers' point of view, there is little to be concerned about when a regulated insurance company changes hands. Claims against automobile and homeowner policies are paid. Life insurance and annuity policyholders may have somewhat greater concern if the guarantee association recoveries have a low ceiling. But it bears repeating that because of conservative reserve requirements, this kind of worst-case scenario is exceedingly rare.

So, should Hank cut the insurers some big checks? The answer is "no." If MetLife flounders, unlike AIG, it is not going to threaten to bring down the whole banking industry.

Part of the insurance business is making smart decisions about how to invest reserves (within regulatory guidelines, of course). Poor decisions should result in companies taking losses, having to set premium rates higher than their competitors, and thus losing market share. These insurance company stockholders should see the value of their shares decrease. They should be upset. Hopefully, they'll shake up management. These are tenets of free market capitalism. It's natural selection at work. In this case, government assistance serves no purpose but to weaken the herd.