The failure of American International Group (AIG) is one driver behind the Obama administration's call for a new federal insurance office, but a key state regulator says the problems started elsewhere.

"The insurers in the AIG system had a lot of capital set aside for their commitments," unlike AIG's derivatives-selling unit, which was supervised by the Office of Thrift Supervision, said Eric Dinallo, New York's insurance superintendent and the main insurance regulator for AIG, in a Tuesday interview. Dinallo has called for insurer regulation to stay with the states; the Obama administration Wednesday is asking that the Office of Thrift Supervision be closed under its proposed revamp of federal regulations.

A draft proposal for expanded federal financial regulation released late Tuesday calls for a new Office of National Insurance "to gather information, develop expertise, negotiate international agreements, and coordinate policy in the insurance sector," according to the draft.

It is unclear what role will remain for the existing system of 50 state insurance departments, which the proposal says "led to a lack of uniformity and reduced competition across state and international boundaries, resulting in inefficiency, reduced product innovation, and higher costs to consumers." A spokeswoman for the National Association of Insurance Commissioners did not immediately have a response to the proposal.

Dinallo, who oversees many of the largest insurance companies in the U.S., said that supervision of big insurers was fragmented, with state regulators having authority only over the companies' insurance businesses, but not their holding companies or other non-insurance businesses. AIG Financial Products, the unit that lost billions through insurance-like derivatives called credit default swaps, was under the supervision of the Office of Thrift Supervision, Dinallo said.

As to the holding companies that own the insurance businesses in a complex corporate structure, Dinallo suggested that it might be a good idea to increase oversight, but he didn't say how that should be done.

The draft proposal calls on the new federal office to make recommendations on "any insurance companies that the Office believes should be supervised as Tier 1" financial holding companies. The government's draft white paper says Tier 1 FHCs are "firms whose failure could pose a threat to financial stability." The draft doesn't spell out whether it will co-exist with state regulation.

Dinallo and others said insurance companies generally have enough money set aside to pay potential claims. Even life insurers that applied for Treasury capital did so to boost ratings or for reasons other than paying claims, he said.

"I don't dispute we could set up a system where we have more capital set aside, but frankly the states did a good job" of requiring adequate capital for the insurance industry, Dinallo said.

Dinallo has set higher capital requirements for some insurers, including bond insurers, but even bond and life insurers have remained solvent, through the crisis, though their capital has been depleted, he said.

Dinallo made the controversial decision in February to allow troubled bond insurer MBIA Inc. (MBI) to split its public finance business from the business that insured mortgage-backed and other structured securities. A group of banks have sued over the split, claiming it removes capital that should be used to cover their insurance. Dinallo said he couldn't comment on the lawsuit, but said that bond insurers remain solvent.

At a Congressional hearing Tuesday, Teresa Bryce, president of mortgage insurer Radian Guaranty Inc. (RDN) argued against new federal-level regulation.

Mortgage insurers do not pose a systemic risk to financial markets because of the insurers' "substantive reserve requirements," she said in prepared testimony.

"We don't create risk, we help absorb risk" by paying claims to lenders when borrowers default on their mortgages, Bryce said in an interview Tuesday.

Mortgage insurers have asked for government help in raising capital, but Bryce said the money is needed to write more insurance, not to pay off claims already made.

-By Lavonne Kuykendall, Dow Jones Newswires; (312) 750 4141; lavonne.kuykendall@dowjones.com