The collapse of financial giant American International Group is more than a cautionary tale about the subprime mortgage mess. It's a wake-up call for anyone who thinks state insurance regulators are up to the task of making sure carriers are sufficiently liquid to pay all conceivable claims. In fact, regulators are doing a frighteningly poor job. It's time for regulation of insurance on a national basis.

In 1945, Congress passed the McCarran-Ferguson Act protecting insurers from any uniform regulatory scrutiny. The job of making sure that carriers are financially able to pay claims is left to a series of state regulators — most of whom are weak and underfunded, many of whom have political agendas inconsistent with challenging influential insurers.

Regulators outgunned

State insurance regulators keep track of the financial condition of every insurer doing business within its borders, making sure it has enough liquid capital to pay claims. Yet, regulating carriers must compete for state tax revenue with schools, repairing roads and fighting crime. It's a losing battle. As a result, regulators are vastly outmanned and outgunned by the insurers they are tasked to restrain.

A dozen states have elected insurance commissioners. The rest are appointed by governors. Some argue that insurance regulators should be appointed because elected officials are too susceptible to insurer influence. Others argue that regulators should be elected because appointed commissioners have no public accountability. Both sides assume that effective state regulation of insurance companies is actually happening. Strong evidence suggests that it isn't.

Consider AIG, a massive company that sells insurance and financial services. The subprime mortgage crisis hit it hard. AIG had sold a lot of credit default swaps, products protecting lenders and secondary-market investors from the risk of defaults on debt. The deterioration of mortgage portfolios holding subprime debt prompted claims under these products. The financial markets and rating agencies began adjusting the company's value to reflect impairment to its capital when it paid these claims.

AIG's counterparty bond rating fell, allowing counterparties in credit default swaps to demand additional collateral to ensure payment of claims. Analysts estimated a $25 billion loss on these products, and the company's stock price plummeted. Very quickly, AIG reached the brink of bankruptcy.

A bright idea

Then, somebody came up with a bright idea. Although AIG, the parent company, was in terrible financial condition, AIG's insurance company subsidiaries were in relatively good shape.

As required by New York insurance regulations, these insurers had set aside cash to cover statistically likely claims. What if these insurers made a loan to their parent, secured by some of AIG's deteriorating assets? This would instantly improve the AIG balance sheet, clearing the way for a much larger loan from the Federal Reserve.

So, AIG asked New York Gov. David Paterson and Insurance Superintendent Eric Dinallo to approve a $20 billion loan by the insurer subsidiaries of their cash reserves set aside for claims, for a note secured by lousy assets that AIG couldn't profitably sell. Incredibly, they agreed. The transaction was publicly announced. No one complained. Life went on.

As it turned out, the $20 billion loan was never funded because the Fed provided AIG with taxpayer money instead. But note what just happened here. With AIG in a death spiral, its senior managers in effect grabbed $20 billion (that's billion with a "b") in set-asides for policyholders. And chief regulator Dinallo and his boss let them do it. No single act of the regulator of a state in which many carriers are headquartered could better illustrate how dangerously irrelevant state insurance regulation has become.

Monumental failure

Dinallo certainly knows better. He is former general counsel of insurance broker Willis Group Holdings, and former managing director and head of regulatory affairs for Morgan Stanley. In giving his buddies at AIG a helping hand, Dinallo showed just how rapidly and completely a state insurance regulator can fold when the chips are down. This was a failure of insurance regulation on a monumental scale. Not only did the security guards fail to keep the bank robbers out, they unlocked the vault and helped load the truck.

Other cornerstones of the national economy, such as the banking and securities industries, are regulated by the federal government, rather than the states. The insurance industry is no less vital to American security and prosperity. A uniform hand at the tiller, backed by federal law, would guarantee what policyholders do not have now: the assurance that carrier capital will be preserved for all conceivable claims, even if a parent company collapses.

If AIG can plunder subsidiary insurers with impunity, without even attracting the public's attention, then the absence of effective regulation is a national disgrace reparable only by national oversight.

— David Wood of Camarillo is a partner in the Ventura firm of Wood & Bender and a nationally recognized attorney in the area of insurance policy enforcement. He serves on the boards of Casa Pacifica and the Camarillo Boys and Girls Club.