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April 9, 2007
Honorable Joseph Torti, III
Rhode Island Superintendent of Insurance
Chair, NAIC Financial Regulation Standards and Accreditation "F" Committee
233 Richmond Street
Providence, RI 02903
Re: Annual Financial Reporting Regulation
Dear Superintendent Torti and members of the “F” Committee:
On behalf of FreedomWorks, a nonprofit, nonpartisan organization with approximately 800,000 members nationwide, I respectfully submit these comments on the proposed Model Audit Rule for your consideration. Our mission is to educate citizens on, and to promote the adoption of, free-market policies, which we believe inure to the benefit of consumers and citizens generally.
Introduction and Executive Summary
One of the key areas of research at FreedomWorks has been the impact of regulation on consumers. We have examined regulations across the economy, and have had an insurance project for the past 10 years. On behalf of the members and supporters of FreedomWorks, I urge the National Association of Insurance Commissioners not to adopt the new Model Audit Rule as an accreditation standard. Doing so would punish states that do not extend the reach of Sarbanes-Oxley type regulations to private and mutual insurance companies. Without first conducting a thorough cost-benefit analysis to evaluate the impact of the proposed rule, there is little to demonstrate that such rules would provide additional benefits commensurate with their costs.
This letter will discuss and advocate the following:
· There is a basic mismatch between applying regulatory standards designed for SEC-regulated public companies to state insurance department-regulated insurance companies that are not owned by public investors.
· Sarbanes-Oxley inspired amendments contained in the revised model audit rule represent an extraordinarily invasive regulatory measure based on legislation passed for the stated purpose of stabilizing investor confidence in light of a series of public company collapses—a predicate and rationale not relevant to the solvency regulation of non-public insurers.
· Before using its unique, Congressional-like power to virtually legislate a national standard, the F Committee should incorporate established and accepted cost-benefit review procedures for the proposed regulations to ensure that projected savings to consumers and the public justify the imposition on commerce that the regulations represent.
Basic and Crucial Differences between Securities and Exchange Commission (SEC) Regulation and Insurance Regulation
There are important distinctions between the operations of, and the basic regulatory regime pertaining to, insurance companies and the SEC-regulated, publicly traded companies specifically targeted by Sarbanes-Oxley. First and foremost, many insurance companies are non-public, and therefore do not require mandates or new oversight to protect the investing public.
Secondly, insurance companies are subject to a far greater degree of oversight and financial regulation by state insurance commissioners than public companies are by the SEC. The extensive and thorough on-site solvency examinations by the domestic regulator of every licensed insurance company have no SEC analog. Since self-reporting by public companies and their retained auditors is the essence of the SEC’s regulatory regime, tighter controls over companies’ internal processes and their relationships with their auditors were perhaps a more reasonable response to concerns regarding public company solvency. State insurance regulators, however, do not have such reliance on self-reports. Adding costly new requirements geared toward internal and auditors’ operations may simply increase costs and harm consumers through subsequent upward pressure on premiums, while providing few additional corresponding benefits in terms of improved levels of solvency.
We note that the NAIC has moved toward a principles-based approach to regulating life insurance reserving practices. Keeping this in mind, and applying a principles-based approach to regulation currently encouraged by the SEC and others, suggests that Sarbanes-Oxley type mandates are less appropriate for the insurance industry, especially the oversight of non-public and mutual carriers.
The Public Company Accounting Reform and Investor Protection Act of 2002, more commonly known as Sarbanes-Oxley, was passed in the wake of corporate governance scandals at Enron and WorldCom. Rightly or wrongly, policymakers viewed this drastic and invasive measure as a necessary step to restoring and sustaining investor confidence in response to historic blows to the public’s perception of corporate integrity. No insolvencies of similar magnitude or public notoriety have occurred in the insurance context. And no public investors are present in non-public insurance companies. We note that Rep. Oxley himself, who ought to have known the proper scope and purpose of the law bearing his name, wrote to the NAIC during the development of the new Model Audit Rule, explaining:
It was determined at the time of consideration, and after much deliberation, that the SOX reforms should only apply to publicly traded companies as the overall goal was to protect investors and restore confidence in the Nation’s security markets.... Congress deliberately made the decision to apply the law only to those companies registered with the Securities and Exchange Commission (SEC).
Furthermore, the effectiveness of Sarbanes-Oxley has been questioned as its results have been assessed. The legislation is perhaps the most sweeping increase in the regulation of American corporations since the Great Depression. Unfortunately, these regulations have created significant burdens on American businesses that raise costs and make it more difficult to compete in the increasingly competitive global capital market.
The legislation has imposed unintended, but substantial, costs on American capital markets. Indeed, while the Securities and Exchange Commission initially estimated a regulatory compliance cost of $1.25 billion, more recent studies suggest that the regulatory burden is perhaps 20 times higher. Furthermore, Sarbanes-Oxley was the impetus for a thorough and alarming report publicized by Senator Charles Schumer and Mayor Michael Bloomberg, which concluded that over-invasive financial regulation may be threatening the stability and prosperity of American markets. The report urges a more prominent role for regulatory review in order to maintain leadership in global capital markets. In particular, the report suggests a greater reliance on cost-benefit analyis: “The SEC should establish explicit principles of effective regulation that will guide its activities to meet its statutory obligations. These principles should include the systematic implementation of a carefully applied cost-benefit analysis of its proposed rules and regulations. Rules should not only be evaluated initially at the front-end, but also should be reviewed periodically to ensure that they are achieving their intended effect at an acceptable cost.”
Sarbanes-Oxley includes a number of reforms that sought to eliminate conflict of interest problems while strengthening accounting standards. Conflict of interest provisions are particularly relevant to companies subject to SEC regulation because the SEC’s oversight is wholly dependent on companies’ internal reporting and the audits by their retained outside accounting firms. These concerns, though not irrelevant, are not as substantial for regulated industries, such as insurance, where the regulator does regular on site examinations of the subject companies.
Excessive paperwork and burdensome regulations can thwart economic growth and hamper the global competitiveness of the U.S. economy. This has been an especially important concern with respect to the regulatory burden of Sarbanes-Oxley, where new rules have contributed to the decline in public offerings in U.S. markets: “As measured by value of IPOs, the U.S. share declined from 50 percent in 2000 to 5 percent in 2005. Measured by number of IPOs, the decline is from 37 percent in 2000 to 10 percent in 2005.” Indeed, Paul Atkins, a commissioner at the SEC recently commented:
It has been extremely burdensome to implement. The implementation difficulties surprised a lot of people. The Senate committee report on Sarbanes-Oxley observed that high quality audits already ‘incorporate extensive internal control testing’ and that the committee did not expect the internal control provision to be the basis for any increased fees or charges by outside auditors. Similarly, the SEC estimated that implementation of Section 404 would cost an average of $91,000 per company, for a total of one and a quarter billion dollars. Estimates have put actual costs at more than 20 times that amount.
Sarbanes-Oxley, including some key provisions incorporated in the new Model Audit Rule, has thus required substantial changes to company practices that have resulted in costs significantly higher than originally estimated.
While the Model Audit Rule under consideration as an accreditation standard was somewhat scaled back during the process of its adoption as a model, it still contains several provisions expected to lead to substantial costs to insurers, including the requirement that management document and test its internal controls, which will be quite costly and which may lead to a de facto requirement that companies seek an independent attestation, either through business caution or because regulators will later seek to require it. And, most importantly, as discussed in greater detail below, there has been no effort by the NAIC to quantify either how much the cost-benefit ratio of the new regulation improved with the amendments which scaled back the regulatory burden, or what a credible estimate is of the current cost-benefit ratio of the new MAR.
It is also important to note that these new requirements have had a disproportionate impact on small businesses, which have struggled with the costs of establishing the required oversight systems. The model audit rule exempts smaller companies but this raises an important question with respect to solvency oversight. If solvencies are more problematic with smaller firms, the exemption would be unwise. Conversely, if solvencies are not more problematic, it may suggest that current levels of oversight are sufficient and increased regulatory burdens are unwarranted. Expanding the use of such regulations without first carefully analyzing the impact threatens to reduplicate these concerns in other sectors of the economy.
Sarbanes-Oxley Was Not Meant for Insurance Markets
For many non-public insurance companies, the proposed rule would mandate changes in current business practices that would only increase costs in the insurance sector and hinder the marketplace for insurance in ways that harm consumers. Historically, government “fixes” to real and perceived abuses have come too late, long after the markets have self-corrected. Too often, the net result of new legislation or a hasty regulatory action—ostensibly to “protect investors” in the case of Sarbanes-Oxley—does little to address past abuses. Burdening legitimate companies and investors with new oversight and paperwork only serves to slow the efficient flow of capital. Ironically, government intervention often ends up punishing small investors and stockholders, while “rewarding” the very agencies and regulators that failed to catch the wrong-doers in the first place. The end result is a steady growth in government budgets, oversight, and paperwork. Public choice economists refer to this cycle as “government failure.”
Applying Sarbanes-Oxley style rules to the insurance sector, which is already governed by a regulatory framework that is stricter than the SEC’s, and that aims to protect policyholders rather than investors, would increase compliance and administrative costs in firms that adopted accounting practices to demonstrate solvency. In fact, it is not obvious that the new rules would help state regulators achieve their goal of ensuring solvency. Cost-benefit analysis would provide a better understanding of the issue. This has been a common practice for federal regulators for some time; however, because insurance is regulated at the state level, there has not been the same degree of interest in developing careful analysis to demonstrate that the benefits of a given rule exceed its costs.
The Importance of Regulatory Review and Cost-Benefit Analysis
As the federal government has grown in size and complexity, centralized regulatory review has become an integral tool of the executive branch's efforts to ensure that policies are consistent across agencies and that additional regulations generate benefits that exceed their costs. The importance of regulatory review has been acknowledged by the fact that all presidents in recent history have made some attempt to improve the regulatory process and minimize the economic drag of excessive regulations. Richard Nixon's Quality of Life review was the first effort to coordinate regulations across agencies. These efforts at White House review were continued under Gerald Ford through the use of Inflation Impact Statements. President Jimmy Carter then established the Improving Government Regulations Program, which relied on a number of offices within the Executive Office of the President to evaluate the impact and cost-effectiveness of regulatory activities. The current requirement for regulatory analysis on any rule with an impact of more than $100 million on the economy was established under President Carter.
Building on the framework established by President Carter, President Ronald Reagan established a more formal procedure for regulatory analysis that required cost-benefit analysis for federal rules where not statutorily prohibited. This was the foundation for federal regulatory analysis conducted throughout the 1980s and early 1990s.
Simply put, federal agencies should regulate only in those cases where information is available on the impact of the proposed regulation, and only in those instances where the benefits of regulation exceed the costs. In addition, agencies must choose the least-cost alternative when promulgating regulations.
Upon taking office, President Clinton also expressed his concern for excessive regulation and signed Executive Order No. 12866, "Regulatory Planning and Review" to govern the regulatory review process. This framework remained in place unchanged until January 2007, when President Bush amended the Clinton executive order to include the review of guidance documents as well as official regulations.
Treasury Secretary Henry M. Paulson recently commented on the need for regulatory reform and cost-benefit analysis, especially with respect to financial services markets: “Our regulatory system has served us very well over the course of our history. It is part of the foundation for our prosperity and growth. And, robust and balanced regulation is critical to ensuring that we continue to have the strongest capital markets in the future. Yet, the addition of new regulators over many years, and the tendency of these regulators to adapt to the changing market by expanding, as opposed to focusing on the broader objective of regulatory efficiency, is a trend we should examine. We should assess how the current system works and where it can be improved, with a particular eye toward more rigorous cost-benefit analysis of new regulation.” This is true for insurance markets as well.
The NAIC’s accreditation process has reached a point where it should incorporate such practices, particularly when promulgating and reviewing a standard as invasive and potentially expensive to regulated entities as the Model Audit Rule. The coercive power of the NAIC over the states through accreditation mirrors that of the federal government. The accreditation process essentially bestows the power of a federal regulatory agency in the NAIC since, as a practical matter, the adoption of an accreditation standard by the NAIC will cause virtually every state to impose the rule upon all companies doing business within its borders. This power must be exercised responsibly.
We understand that a credible cost-benefit analysis was performed which concluded that the burdens of an earlier draft of the Model Audit Rule would outweigh the benefits by 8 to 1. We also understand that the final draft which passed the Plenary included changes which were designed to lessen the burden. But, to our knowledge, no effort was made to quantify the resulting burden. Our sense is that the burdens will still substantially outweigh the gains. The F Committee should not guess or use a gut feeling in assessing the costs and benefits. Instead, we respectfully suggest that it should seek a credible estimate of both the gains and detriments which are likely to result from the national imposition of a burdensome rule represented by accreditation.
Once again, thank you for the opportunity to comment on this important issue. As a consumer group that promotes the benefits of competition in an open market, FreedomWorks sees great potential for consumer gain through a strong and competitive marketplace for insurance. However, we are concerned that current attempts to impose Sarbanes-Oxley style regulations on the non-public and mutual companies may lead to increased costs with little benefit for consumers. Prior to any changes we would urge a thorough cost-benefit analysis of the new rules. We encourage the National Association of Insurance Commissioners to continue efforts to establish a more competitive marketplace as it reviews its regulatory framework for this vital sector of the economy.
Wayne T. Brough
Chief Economist, FreedomWorks
Cc: Honorable Walter Bell, NAIC President
Honorable Sandy Praeger, NAIC President-Elect
Honorable Roger Sevigny, NAIC Vice President
Honorable Jane Cline, NAIC Secretary-Treasurer
Honorable Barney Frank, Chair, House Financial Services Committee
Honorable Spencer Bachus, Ranking Member, Financial Services Committee
Honorable Paul Kanjorski, Chair, Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises
Honorable Deborah Pryce, Ranking Member, Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises
 Letter reprinted as Appendix B in Charles M. Chamness, “Status Report: NAMIC Advocacy Against Extending SOX Internal Controls to Non-Public Companies,” National Association of Mutual Insurance Companies, November 2005.
 “Interim Report of the Committee on Capital Markets Regulation,” Committee on Capital Markets Regulation, November 30, 2006.
 Ibid. p. 8.
 Ibid. p. x.
 Opening Remarks by Treasury Secretary Henry M. Paulson, Jr. at Treasury’s Capital Markets Competitiveness Conference Georgetown University, March 13, 2007. Available at http://www.ustreas.gov/press/releases/hp306.htm.