LIFE INSURANCE: REGULA T ION AS CONTRACT ENFORCEMENT 1

Life insurers, and mutual life insurers in particular, have recently attracted a great deal of attention. The UK’s Financial Services Authority (FSA) and its predecessors have received some severe criticism, most recently in the Penrose report into Equitable Life’s problems. While the press commentary is interesting and useful, it frequently fails to adopt a sufficiently long view of the retail financial services industry. In particular, there is surprisingly little discussion of the rationale for regulation. It seems pointless to debate regulatory policy without a clear understanding of why insurance companies are regulated. In this essay I provide a rationale: I suggest that the regulator’s role should be simply to enforce contracts into which insurers and their customers wish to enter, but which they cannot commit to honour. This approach expands the universe of available insurance contracts and so facilitates the workings of the insurance market. It has some clear normative implications. In particular, I argue that it suggests that insurers should be regulated only to the extent that they wish to be. Furthermore, there is no clear a priori reason for the insurance regulator to be a monopolist.Regulation interferes with the free operation of the market in pursuit of greater social welfare. It is a hazardous occupation: freedom of contract is a central pillar of liberal democracy. Moreover, neoclassical economics (e.g. Arrow and Hahn, 1971) confirms under some fairly restrictive assumptions Adam Smith’s (1776) intuition that, in helping themselves, the self-interested counterparties to a contract ensure an efficient use of resources. The Austrian school of economists have argued further that a free market fosters innovation and discovery (see, for example, Hayek, 1948). So we should tread very carefully when designing regulations. It is today well understood that even well-meaning attempts to alter the market process frequently have unforeseen and welfare-reducing consequences. And of course regulation need not be well-meaning: large corporate interests may capture the institutions which oversee them.