An alternative to the weaknesses inherent in federal and state regulation of insurance might be the concept of “competitive federalism,” an insurance industry expert suggested recently.

Martin F. Grace, professor of risk management and insurance at Georgia State University, said he was “somewhat despondent” about the history of state-based insurance regulation and is “uncomfortable but dimly in favor of moving toward a national regulator.”

“The general consensus in the academic community is that price regulation has hurt the insurance market,” he said, referring to efforts to create an optional federal charter system or federalized insurance regulatory system.

Speaking at the Networks Financial Institute Insurance Reform Summit in Washington, D.C., earlier this month, Grace said the concept of competitive federalism could solve some of the problems endemic to both state-based and proposed federal regulation of insurance.

He noted that once an insurance company elects federal regulation, it would become cost prohibitive to revert back to a state mode of regulation, providing the federal regulator with a captive market and an incentive to extract extreme rates. However, under a competitive federalism approach, insurance companies doing business in multiple states could select the state under which they wanted to be chartered and move their regulatory state as needed. He did note the need for legislation requiring states to recognize regulations imposed by other states.

He argued that any discussion of state versus federal regulation must take into account not only who the regulatory agency is, but what should be regulated. The consequences of risk, especially market failures, rather than the individual company, must be addressed.

“The goal of effective regulation is to minimize the costs of market failures and also the cost of the regulation,” he said, adding, “Historically, we have looked at the ‘who’ versus the ‘what’ when regulating. We need to regulate the price of the risk.”

Calls for an optional federal charter, allowing carriers to choose either federal or state regulation, could present insurers with economies of scale and a reduction in their compliance costs, both of which become more important in tougher financial times, Grace said.

Arguments that state-based regulation foster competition and innovation seem invalid, although he did say a push toward uniformity could discourage some experimentation. But he said state-based regulation has not typically encouraged significant innovation.

Referencing the National Insurance Modernization Act set to be introduced, Grace expressed concern that the regulation borrowed on consumer protection ideas dating from the 20th century. Noting that legislation should determine what is regulated and how it is regulated while ensuring that the social cost is minimized, Grace said that the new proposal may in actuality increase the cost to society. He said that while all states already have “fair pricing,” their definitions vary.

New proposals may shift risk from low-risk to high-risk individuals, resulting in mispriced risk, according to Grace. He said that all insurance crises in the past 30 years could be attributed to mispriced risk and that the new proposals do not address the issue. Compulsory markets could be potentially affected and guaranty funds could be further stressed.