WASHINGTON—The idea that some financial institutions are too big to be allowed to fail should be rejected “entirely,” the chairman of the Senate Banking, Housing and Urban Affairs Committee said Tuesday.

Sen. Chris Dodd, D-Conn., made the comment during a committee hearing on insurance regulatory modernization, during which a panel of outside experts discussed the Obama administration’s financial services regulatory reform plan as it would affect insurance.

In response to a question from Sen. Tim Johnson, D-S.D., a proponent of optional federal charters for insurers, Hal Scott, Nomura professor of international financial systems at Harvard Law School in Cambridge, Mass., said he didn’t think the administration’s proposal “goes far enough.”

Mr. Scott said insurers should be allowed to choose a federal charter, and some large insurers should be required to be regulated by federal authorities rather than state authorities. The administration plan calls for establishing an Office of National Insurance within the Treasury Department, but says nothing about federal insurance charters. Mr. Scott also said that rather than be a part of the Treasury Department, the ONI should be an independent agency like the Securities and Exchange Commission.

The ONI “is a good first step,” Martin Grace, James S. Kemper professor of risk management at the Department of Risk Management and Insurance at Georgia State University in Atlanta, told the panel, adding, “Let’s see how the first step goes.”

After hearing the panelists’ comments, Sen. Dodd said that unlike the highly politicized debate over health care reform, discussions of financial services regulatory reform in his committee have been marked by a desire “to figure out what works.” He added, “we don’t want to miss the opportunity the crisis has posed.”

But in the discussion of systemic risk regulation, he said, “I want to get rid of this too-big-to-fail notion entirely,” referring to the rationale behind government intervention to save American International Group Inc. and some other institutions. His sentiment was shared by the committee’s top minority member, Sen. Richard Shelby, R-Ala.

“The sky didn’t fall when Lehman Bros. went under,” Sen. Shelby said. “If we enshrine the too-big-to-fail doctrine, we’re going to have problems down the road.”

In a related development, a group of financial services industry organizations sent a letter Tuesday to Sens. Dodd and Shelby advocating a greater federal role in insurance regulation.

“Our coalition believes that to effectively address gaps in regulation of insurance in a way that would be most beneficial for insurers, reinsurers, producers and, most importantly, consumers, Congress should also establish an appropriately crafted functional federal regulator for insurance,” the Coalition for Insurance Modernization said in the letter. “While state insurance regulation should remain available for those who choose it, particularly agents who may only do business in a few states, a federal alternative regulator could help spur innovation and competition, increase choice, reduce costs, and provide meaningful and consistent consumer protections.”

Members of the coalition include the American Insurance Assn., Agents for Change, the American Bankers Insurance Assn., the American Council of Life Insurers, the Council of Insurance Agents and Brokers, the Financial Services Roundtable, the National Assn. of Independent Life Brokerage Agencies, the National Assn. of Insurance and Financial Advisors and the Reinsurance Assn. of America.