Commentary: Why It's So Easy To Scam Small Insurers

It was the perfect crime, as only novelist Ian Fleming could have conceived: A charismatic con man who moved between Connecticut society and the Vatican hierarchy using any of five aliases. A mysterious suicide at a reclusive financier's ritzy Greenwich compound. A byzantine network of insurance companies, all investing through the financier's London trading firm. And in the end, two fireplaces left ablaze with shredded documents, funds hastily wired to Swiss banks, and the disappearance of financier Martin R. Frankel, a.k.a. David Rosse and Eric Stevens, without a trace.

Except that Frankel isn't a figment of Fleming's imagination but the mastermind behind a real-life Ponzi scheme involving $215 million--or much more--in missing funds. So far, Frankel's scheme has rendered insolvent two insurance companies that gave the fugitive financier funds to invest, left at least five others exposed--and raised disturbing questions about the adequacy of the state regulatory agencies charged with playing public watchdog over the nation's insurers.

COMPLEX TIMES. In an era in which global insurance conglomerates hedge their risks through complex derivatives and other financial exotica and move funds in and out of shadowy offshore affiliates, the network of humble state examiners suddenly looks like an anachronism from a simpler time. "Regulation in most states is inadequate," argues J. Robert Hunter, a former Texas insurance commissioner who now serves as insurance director for the Consumer Federation of America. "How do examiners in Oklahoma know that funds are being shifted across borders with the click of a mouse? And even if they do, does Oklahoma work out a treaty with England or the Vatican?"

If there are any lessons to be learned from the Frankel saga, it may be that it's time for the federal government to assume an expanded role in regulating the nation's insurance companies, just as Uncle Sam serves as watchdog over banks and securities firms. At a minimum, the U.S. should adopt the Canadian model, which lets the federal government set solvency standards while leaving sales practices and other consumer issues to the provinces.

Granted, federal oversight raises issues of its own--namely, whether giving Washington a larger role creates an implicit taxpayer liability to cover the costs of any solvency crises. But it's fair to question whether states are up to the task of regulating the new breed of insurers. Truth is, in many states the insurance office is viewed not so much as a watchdog as a cash cow that lawmakers milk for other pet projects.

Consider this: According to the A.M. Best Co. rating service, between 1991 and 1995, U.S. insurers paid more than $43 billion to the states in taxes, fines, and other fees. Yet state insurance departments received just $2.8 billion, or 6.5% of those fees, in funding from their legislatures. Among the worst were--perhaps not coincidentally--the Southern states that Frankel targeted: Tennessee, which according to Best spent just 2.4% of the insurer fees it received in 1995, and Alabama, at 2.6%. "Regulators do need more money," maintains Michael A. Bownes, general counsel for the Alabama Insurance Dept. "Most departments are understaffed and underbudgeted."

The result isn't trivial: While banks are examined annually, most insurers undergo a thorough review only every three to five years. "Whose interest is this kind of time frame protecting?" Neil D. Levin, insurance superintendent for New York State, asked at an industry symposium last fall. "Is the regulator pretending to regulate, and are companies pretending to be regulated?"

This fragmented system also perpetuates a form of "regulatory arbitrage" in which insurance companies shop for the most accommodating regulator. After Alabama ordered one insurer to move its reserves from Frankel's brokerage to the safety of a bank, the insurer simply transferred its headquarters--at least on paper--to Mississippi and maintained the status quo. As long as such practices are permitted, mystery writers won't lack for material to write about.

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE