Interview: N.Y.'s Eric Dinallo Backs Liddy, Sees Success in

As New York Insurance Superintendent, Eric Dinallo has found himself thrust into the midst of multiple firestorms ? AIG, bond insurance and the shifting role of state regulators in overseeing complex organizations and offerings. On March 23, he visited with BestWeek editors for an extended interview that captured his views on a multitude of fast-developing issues.

Video of this interview is available at:

http://www3.ambest.com/ambv/media/video.aspx?rc=154835

http://www3.ambest.com/ambv/media/video.aspx?rc=154779

BESTWEEK: We?re joined today by New York Insurance Superintendent Eric Dinallo. He took office in January of 2007 and was confirmed by the New York state Senate in April of 2007 as the 39th superintendent of the New York State Insurance Department. As superintendent, he has been a national voice for efficient, effective regulations to protect consumers and foster a healthy, competitive market for insurance. During his tenure, the department was given the 2008 Esprit de Corps Award by the National Association of Insurance Commissioners for outstanding services to state insurance regulation.

Superintendent Dinallo worked with the United States Treasury Department, Federal Reserve Bank of New York and others in the rescue of financial services giant, AIG.

Superintendent Dinallo has testified to both houses of Congress 11 times in less than two years, leading the call for regulation of the credit default swaps that were instrumental to the onset of the current financial crisis.

BESTWEEK: You?ve got a pretty strong opinion on the idea of optional federal regulation and optional federal charter; in fact you?re on record as saying it?s a horrendous idea.

DINALLO: The part that I find really problematic is the optional part. People don?t really step back and think about what we just went through in the last couple of years and how a lot of it is because of the opportunities for regulated entities to pick their own regulator. I?m not one of the state regulators who is completely against any federal regulation. There is good opportunity there, we should discuss it.

But the concept that you would inject more optionality into a regulatory regime that already has had problems because we?ve been able to pick our regulators, is the part that bothers me. And there?s been statistics around regulatory arbitrage. The Washington Post had an article about a month ago showing that a lot of banks actually switch in the middle of exams, in the middle of fine procedures ... I just think that?s unacceptable. The regulatory relationship should be sort of decided ab initio and it ought to be more like a marriage, sort of a committed exchange rather than a one-night stand.

BESTWEEK: In light of recent events, though, we do seem to be headed in that direction, don?t we?

DINALLO: I think we?re headed to federal involvement in insurance. I really hope we?re not headed to the optional part. That?s the thing that, to me, will lead to this incredible distancing that goes on where you basically say, 'I don?t really want you to be too much in my hair, so I?m going to go and be with somebody else.' That?s really not a regulatory relationship. I just don?t feel comfortable with a regime where we pick our own regulator. To some extent, that?s what happened with AIG.

BESTWEEK: Where do you think it would be appropriate and what are you hearing from the other commissioners?

DINALLO: There are areas like reinsurance, which is a completely fungible, capital intensive undertaking that?s not really consumer-oriented ? that would maybe make some sense. You could have some discussion around life insurance ... or credit insurance companies, which have turned into this huge, global insurance dynamic that?s now been something where the rest of the world economy got pegged onto. That might be a rational area. Also federalization of certain standards ? licensing, product development, maybe solvency requirements. Those are all areas where you would federalize in a way that would help consumers, frankly, and certainly help the industry.

Some commissioners, depending on their level of experience, seem pretty comfortable with some [federal] involvement. Some seem ready to help lead. Others are clearly more concerned about their local issues, which is the reason there is a split on this. When you?re talking about consumer issues, private lines, etc., you get right to the split and the concept that Tim Geithner or anyone in the federal system is going to start dealing with auto insurance complaints to me is really something that I fantasize about actually.

BESTWEEK: There?s been some talk about the possibility of an office of insurance information that would report to Congress on a regular basis. How do you feel about that?

DINALLO: It?s a fabulous idea. I credit Congressman Paul Kanjorski for being open and candid about what our federal system was up to and what it needed. He sensed a real need for better knowledge around insurance. He stepped up and said, 'Look, we can have a debate about federal regulation of insurance, but the first step is to have Congress and the federal government understand insurance more and have a place where we can collect that information.'

Some people think it's sort of the camel?s nose under the tent. I actually don?t believe that, because that particular congressman is not a fan of large monolithic agencies. I think he really wants to just get a better grip around insurance as a topic that is now probably the most healthy part of our financial services world, and he wants to make sure that Congress, the executive branch and our whole country is better informed in a unified way.

BESTWEEK: You?ve talked about the idea of a New York insurance exchange, but not until the economy improves. What would such an exchange entail and why wait until the economy gets better?

DINALLO: I was acknowledging that people thought that it was a little bit off-cycle to be talking about it now but I?m looking down the road for when the economy picks up. And when the economy picks up, I think you?re going to see the continued appetite of Wall Street, which will inevitably come back, hedge funds and private equity for what I call uncorrelated risk. Insurance and the kind of insurance you can do in your insurance exchange is classically uncorrelated. It?s around reinsurance. It?s going to be around catastrophic, terrorism ... the kind of insurance that requires large syndicates to come together and underwrite that.

The World Trade Center would have been the kind of insurance that you could have walked into the New York insurance exchange and put together a syndicate around it. And there?s clearly capital out there that didn?t exist 20 years ago when it first opened and failed that wants access to that but considers cat bonds and sidecars to be very expensive, very legalistic ways of doing it. We could offer to the country, federalization of insurance without the federal government in this way: We?ve always talked about passporting for reinsurance, one-state shopping for it. The New York insurance exchange, which had been admitted in the other 50 states previously, would offer that kind of opportunity to the reinsurance market. It?s still on the books, it?s still in the statutes, the regulations are still there, all it needs is that kind of capital push that I think is inevitable. Also, if we could get a tax break, that would be a big deal.

The reason, obviously, that everyone goes to Bermuda and goes to Ireland is because of these unbelievable tax opportunities and I feel like the tide is changing there. You see Congress getting a little bit upset that there?s this strange tax opportunity when a lot of the business is really happening and the capital is coming through the books in the United States and being washed through a reinsurance opportunity in Bermuda ? legally, not illegally. It?s classic tax avoidance as opposed to tax evasion. I think Congress may land on that eventually and the New York insurance exchange should be poised to pick that up. It's huge ? tens of billions of dollars in business that we have lost completely overseas in a marketplace that ought to be able to pick that up. It?s a great leading opportunity for New York.

BESTWEEK: Credit default swaps have been in the news a lot lately. What is your view of them?

DINALLO: They?re the great enabler of this financial meltdown. I don?t think they?re responsible for our financial meltdown, but they gave people and the whole marketplace a very false security over what they thought they had. They thought they had insurance behind credit default situations. So they thought when they brought CDOs onto their books ? Wall Street in particular ? they would turn to their credit managers and their risk managers and say, ?I?m good for the downside, I have a CDS,? or ?I have insurance.? They literally used that term. The reporters used that term, but in no way were they capitalized like insurance. So it?s either gambling or directional bets when it?s a naked CDS ? when you don?t actually own the bonds and you?re just expressing an attitude about the company?s creditworthiness or it?s a covered swap and it really is essentially an insurance policy, because you own the bonds and you want to insure against that default. You?re swapping the risk with somebody else. But in both buckets, we?ve never capitalized them like insurance.

There are four basic buckets that I?ve thought and talked about. This is what our regulatory regime has to recognize. There?s banking, like commercial banking. I give you my savings, you are a bank, basically it?s guaranteed that I?m going to get that back, plus 2%. The whole FDIC system is built around that. Insurance, similarly, is pretty much a guaranteed undertaking ? your house falls down, I?ll pay you. Our whole system and the guarantee funds are around that concept. Thirdly is gambling. Frankly, regulated speculation has a certain amount of capital set aside whether it?s Vegas or the race track. And the fourth bucket is investment banking which is purely speculative and you could lose all your money. Your IBM stock is worth $70 today but it could be worth zero ? see what happened with Bear Sterns and Lehman. All four of those require different capital regulatory regimes and we took the fourth ? investment banking ? and we marketed CDSs, which are really essentially derivatives of securities, but we held them out as if they were insurance or gambling and there were regulations that put capital behind them to create the kind of solvency you would expect if there was a

guaranteed payout. But there was none. And so the whole world all of sudden woke up and realized they were holding what they thought were insurance policies behind these gross securitizations and speculation, and it wasn?t there. And that?s one reason why you saw an exacerbation of the credit freeze ? because all of a sudden everyone realized they didn?t really have insurance on something that they thought they had.

BESTWEEK: Let's talk a little bit about your past life ? before becoming New York superintendent of insurance. You worked for Willis.

DINALLO: I did. I was the general counsel.

BESTWEEK: What did you learn there that?s applicable to your job now and applicable to today?s economic climate?

DINALLO: Going to a broker was a great opportunity because I?ve always felt that one year at a broker was equal to years at an underwriter because you got to see the whole horizon of underwriting and dealing with a system. That made a big difference coming into this job. So although it wasn?t very long, it gave me a huge amount of exposure across the insurance horizon. I also learned about communication. Being so close to the CEO and the management committee I understood how you have to stay consistently on message because you have a regulatory world that wants to hear consistency and understand what the undertaking is. You have a large agency that?s looking for some kind of guidance to understand how you want to go and what direction the new administration wants to go in, all the while recognizing that the administration of the agency that I was honored to inherit was so excellent. So, the other thing is to quickly recognize what you have.

With the New York Insurance Department I felt like we had the premiere insurance regulator in the country and that we could start to do some of the things that we hadn?t historically done, like credit default swaps and some of the other issues that we were confronted with ? settling the World Trade Center ? these were things that for whatever reason the agency had not undertaken before, but I really felt a huge confidence in the regulatory aspect of the agency ? that we had the best regulators in the country and we could begin to do some of the things that the country and the state and the city required right now.

BESTWEEK: I want to ask you about your future. Do you have any political aspirations? What can we look for with you?

DINALLO: Well, I?m just enjoying what I?m doing. I don?t mean that to be a trite answer but when you think about all the areas we and I have been able to get involved in from the New York State Insurance Department ? whether it was AIG or credit default swaps, the World Trade Center, auto rates, beginning the possibility of prior approval in health, the life insurance industry, which is, I think, one of the most amazing and interesting but complicated areas ? I can't imagine a more satisfying situation. So while I?ve always talked about continued public service, I wouldn?t really change anything right now.

BESTWEEK: Superintendent, when we spoke a few weeks ago you expressed some confidence that Ed Liddy and AIG were going to turn the corner on the company?s problems. Are you still optimistic that AIG can turn that corner?

DINALLO: I?m still pretty confident in Ed Liddy himself. I think that the country could not have a better opportunity in having that level of a CEO doing that job for a dollar a year. I do think that we went through a week or two where we came dangerously close to losing sight of the target. So I think that the bonuses are an issue where people should be very upset. I completely acknowledge and understand the frustration and anger around them. But on the other hand, the real target for Ed Liddy is to liquidate, sell these operating companies to pay off the debt to the taxpayers. And if we lose sight that this is really the issue, I think we?re going to have the possibility of permanently damaging the name and when you permanently damage the name of an insurer, as you know, you begin to get into the value of the insurance subsidiary itself. We have to be aware of what the game plan is. And I still have a huge faith in him, I still have a huge faith in the quality of those operating companies and I would like the American public and others to take a step back and while they should be angry about the bonuses and they should have a necessary, correct, instinctual feeling about what

went on at AIG Financial Products and want to hear accountability, what Ed Liddy?s going to do about it, there comes a point where we?re going to lose the target and the target is to pay off the taxpayers through the selling of those operating companies. And that requires healthy, well-branded operating companies. We all have to acknowledge that.

BESTWEEK: With all the activity in Washington ? you have the approaching federal regulator; you have the NAIC setting up office in Washington ? what does that do to state regulation? Do you see any reason to worry that it might undermine what state regulators do?

DINALLO: There is an opportunity; actually, not a problem. You?ve got a system that has, by my estimation, about 15,000 regulators. That?s a very large agency, basically, and I think that the federal government has to step back and think about how they would go about regulating federally. And there is the chance that the NAIC could be granted SRO status. That would not be crazy. The New York Stock Exchange, the NASD ... it would not be the first time that a private entity became an SRO and that might work. But I can?t see the federal government creating a kind of a duplication of a system that is essentially consumer and solvency based and I think on the solvency side it?s done an excellent job. How are we going to have duplication there, and why, exactly? What we did well with AIG was solvency ultimately. I?ve said this before: AIG is not exhibit A for the need for a federal regulator. There are lots of exhibits for the need for a federal regulator of insurance. AIG is not that. AIG is actually exhibit A of how well the solvency part of state-based regulation worked. We have all kinds of issues, we?re clunky, there?s a lot of stuff that I would change if I could wave a magic

wand, but on solvency and the core understanding of having a certain amount of capital behind your commitments, I think we did, actually as a regime, pretty well there. And we should learn from that and say what are really the complaints about our system ? of which there valid ones ? and putting in place a regulatory regime around that.

BESTWEEK: Eric, you were instrumental in getting Berkshire Hathaway to form a bond insurer in New York. What benefits are you seeing from that?

DINALLO: That?s a very good question, you know, because initially I would have expected them to have done more primary wrapping of bond issuance. I think they?ve done ultimately a lot more of reinsurance, which is obviously what Warren Buffet and Ajit Jain are comfortable with. And it?s a smart move there because you have another company in a solvency, that we essentially have stood behind, between you and an ultimate payment. I think that they have not made a huge difference on capacity in the primary market. But at that time I think they fulfilled several important needs by us having them licensed and the reason we spoke to them first and I called Ajit Jain was a) I had the instinct that they had the capital, that was kind of obvious to me. They had the kind of name recognition and I thought they?d get them registered very quickly through the state system and he had a kind of reputation that would have credibility. And thirdly, that Warren Buffet always sends a signal by his activities that it?s safe to go in the water, generally. So, we were in a crisis situation where we wanted to try to send a better signal that we were going to have future capacity and this was an

opportunity. And in that I think he fulfilled it very well. And also I think the state system actually came out looking pretty good because I think a picture or action is better then a thousand words.

So, rather than talking about whether we could license someone jointly and quickly, there we actually acted upon it. The State Insurance Department I think licensed them in about 28 days ? I think less than a month ? and nationally they got licensed in 10 weeks, which is pretty remarkable. And so I think also that part of it was just the object lesson, frankly. And then we were sort of learning from death to birth because we saw the sickly bond insurers and we saw what a perfectly healthy one would look like. And that began ? this was very early on ? but that began the idea that we?d have a three-point plan. So part of that would be the execution of that three-point plan. So, the three-point plan was: Point 1 ? to bring in new players and new capacity into bond insurance, because we could see they were starting to shrivel. Part 2 was dealing with hopelessly or chronically distressed bond insurers, like through rehabilitation or splitting the book or whatever mechanisms we would have. And Part 3 was rewriting the rules of the road.

So we knew we were going to learn a lot through this process and at the end have new regulations and statutes drafted. And I would say that on those three buckets, we did well. We facilitated $15 billion into the sector. We still have not had a bankruptcy, we?ve not had to actually walk anyone into rehabilitation ? we?ve been able to either encourage commutations or capital injections or in the NBIA?s case, separate the business line. And thirdly, we have come up with drafts of new regs and statutes that have been published and there?s going to be debate about do they need to be improved. But in think in one year I?m really proud of the department. How it formulated a plan, executed a plan and messaged the plan. And I think what we did by doing that was that the bond insurers did not become the linchpin on the grenade for the economy. We actually threw our bodies over that, as regulators often have to do, and we let the storm pass over bond insurers into something else pretty successfully.