WASHINGTON--Both sides in the debate over whether insurers should be allowed to choose federal rather than state regulation see the near-collapse of American International Group Inc. as bolstering their case.

State insurance regulators and their supporters argue that state-based regulation worked because AIG's insurance operations have been and remain financially healthy despite the woes of the parent company. But advocates of optional federal regulation of insurers--including Treasury Secretary Henry Paulson--hold that the very size of the AIG losses demands a federal role in insurance regulation.

State regulators maintain that the state-based insurance regulatory system was not at fault in the crisis surrounding AIG, as its problems stemmed from operations that are regulated by other entities. AIG had chosen the federal Office of Thrift Supervision as the global regulator for those units, New York Insurance Superintendent Eric Dinallo, who chairs an AIG Special Task Force of U.S. and foreign regulators, said last week during a press conference at a National Assn. of Insurance Commissioners meeting in National Harbor, Md.

But proponents of an enhanced federal role say that dealing with the insurance aspects of the financial crisis is simply too big a job to be left to the states.

Appearing on NBC's "Meet the Press" on Sept. 21, Mr. Paulson noted that he had issued a regulatory reform blueprint in March "because we have a patchwork regulatory system that is outdated." One section of the blueprint calls for allowing insurers to choose an optional federal charter rather than continue to be regulated by states.

With the optional federal charter, "you'd have a systemic risk regulator who is able to see the whole picture," Rep. Ed Royce, R-Calif., said during a conference call held by Aon Corp. last week for its employees and clients.

"It's time for Congress to reform how insurance companies are regulated," said Rep. Royce, who co-sponsored OFC legislation with Rep. Melissa Bean, D-Ill., in this Congress. "Unless Congress provides an alternative to the state-based regulatory model, I'm afraid the American government, the American taxpayer, (will) be forced to pay for bailouts in the future."

"I think (the AIG situation) shows exactly why we need a 21st century regulatory system for a 21st century industry," said Eli Lehrer, senior fellow at the Competitive Enterprise Institute in Washington, a free-market oriented think tank.

"The New York state regulators were ready to let AIG raid its insurance subsidiaries," Mr. Lehrer said. "While I'm not sure we need to have the federal bailout, what happened was surely better than having policyholders tapped. I think this should significantly strengthen the case for the OFC. The fact that nothing super-bad seems to have happened yet is cold comfort to say the least."

An insurance academic said the nature of the insurance industry could tip the scales toward federal involvement.

"Of all AIG's subsidiaries, only a small percentage were insurance companies," said Norman Baglini, professor of risk management, insurance and business ethics at Temple University in Philadelphia.

"Obviously, the regulators from a number of financial sectors had to be involved," he said. But the AIG rescue could have an impact on the state vs. federal regulation debate "because of the size and complexity of insurance organizations today," which might give a boost to federal regulation, he said.

RIMS urges change

The Risk & Insurance Management Society Inc. sees the crisis as rationale for creating an OFC.

"RIMS has supported the OFC for several years," said Terry Fleming, a RIMS' director-external affairs. "In addition to being inefficient and antiquated, it is apparent from recent events that state-based regulation cannot provide sufficient oversight of insurance companies with multistate and global subsidiaries," said Mr. Fleming, who is director of the division of risk management for Montgomery County, Md. in Rockville.

"Obviously, both sides of the federal regulation debate have been joined like never before, with state regulators arguing that this proves their ability to protect consumers, and supporters of the OFC arguing it proves the necessity of a national regulatory regime, which we strongly support," said Joel Wood, senior vp of the Washington-based Council of Insurance Agents & Brokers.

"At a certain level both sides are right," Mr. Wood said. "When Eric Dinallo and the other state regulators say that those core insurance subsidiaries of AIG were properly regulated and financially secure, there is no evidence to the contrary. But as Secretary Paulson (has said), the holding company was like a hedge fund perched on top of all of those assets. I think that the reality of an $85 billion taxpayer assistance plan makes plain the imperative for federal involvement at the regulatory level."

Policymakers have to understand the difference between AIG as a holding company and its insurance affiliates, said Charles Chamness, president of the Indianapolis-based National Assn. of Mutual Insurance Cos., which supports state regulation. "It illustrates that the segment regulated by the states was the source of strength that enabled the two-year bridge loan to be a prudent" step by the federal government, he said.

But Mr. Chamness said the confusion over which regulatory measures failed points to the need for more insurance expertise at the federal level in the form of an Office of Insurance Information within the Treasury Department. Efforts to create such an office are pending in Congress.

"Congress and the federal government need to have a credible source of information on this important industry," he said.

Financial bailout

Mr. Chamness said that NAMIC is monitoring the implications for insurers in the larger proposed $700 billion financial services bailout. He said he didn't think participants in the debate over that package have the intent to make regulatory changes. "This is all about federal response to crisis, providing some certainty to the market," he said.

RIMS' Mr. Fleming said "there isn't enough information available to assess the impact" of the overall bailout program on the insurance industry. "Based on what has occurred, it appears that some companies may not be transparent with their financial data. We don't know to what extent the industry is at risk with poor investment decisions that they will have to write off."

The debate over insurance regulation may be replaced by "a new debate, and that debate's going to center around the potential need for a systemic risk regulator," said Ben McKay, senior vp in the Property Casualty Insurers Assn. of America's Washington office. PCI opposes the OFC.

"Clearly, if you look at AIG, the insurance part of the company is sound, and in that way, the NAIC has a strong argument," he said. But the debate over what caused the failure is touching on "silos" of influence within financial regulation, in which each regulator is unaware of what others are doing.

Some observers are blaming such silos for the "systemic failure" that rocked the markets, he said.

"The answer is you have to determine if that's in fact true," he said. "Was it siloing of regulation or was it something else, like the approval of one regulator of bad products, i.e., these subprime mortgages? Then you have to determine if a systemic risk regulator would solve that problem."

"I think everybody's using the crisis to their advantage--as I would naturally expect them to do--but I don't think it's at all clear that even relates to this debate," he said. "If you have some companies regulated at the federal level and some at the state level, you still have that systemic divide."