The Convergence of Insurance with Banking and Securities Industries, and the Limits of Regulatory Arbitrage in Finance

Abstract

This Article examines the regulatory challenges raised by recent, overlooked changes in insurance markets that have led to a functional convergence between insurance and the broader financial sector.

The law literature on financial regulation last addressed the issue of convergence over a decade ago, before the latest generation of market innovation and at a time when concern over systemic stability was not at the forefront. This Article revisits the convergence phenomenon in the context of insurance, and does so by applying an analytical framework that distinguishes between two “boundary problems” that accompany all financial regulation. One problem concerns jurisdictional boundaries: to what degree does market integration require that diverse regulations be harmonized across jurisdictions? The other relates to definitional boundaries: within a given jurisdiction, how should distinctions be drawn among financial products or firms that have come to perform similar economic functions?

Applying this framework leads to two conclusions that are in tension with the current thrust of policy as well as the literature. First, the Federal Insurance Office established by the Dodd-Frank Wall Street Reform and Consumer Protection Act is inappropriately structured to leverage international harmonization agreements into domestic reforms, whereas the reverse orientation would be more effective. Second, frequent calls for more “functional regulation” fail to appreciate the subtle advantages of retaining formalistic legal definitions, even in the face of increasing economic convergence.

Although this Article explains how the two boundary problems raise distinct sets of policy tradeoffs, at bottom both are a product of the possibility for regulatory arbitrage across jurisdictions or industry definitions, and the potential for a loosely regulated shadow finance sector to arise. Here, insurance is used as a case study for finance in general, to demonstrate that regulatory arbitrage can occur along a surprising number of fronts, which compounds the difficulty of obtaining reliable ex ante estimates of a proposed financial regulation’s effects.