The Obama administration recently took a long-awaited step by activating for the first time a power granted to the Federal Insurance Office (FIO) under the Dodd-Frank Act to negotiate a “covered agreement” on insurance regulatory issues, in this case with the European Union (EU). If a covered agreement is reached, it would be the first test of this new authority that could result in preemption of one or more state insurance measures.
What is a Covered Agreement?
A covered agreement is a binding agreement between the United States and one or more countries on insurance or reinsurance matters. It can contain provisions that preempt state insurance measures, but only when a state measure treats non-U.S. based insurers less favorably than U.S.-based insurers. Whatever its provisions, a covered agreement must provide similar consumer protection to current state laws.
Prior to Dodd-Frank, the federal government had no mechanism to preempt state insurance regulation. Dodd-Frank created a new authority to negotiate covered agreements and gave that authority to the Federal Insurance Office of the U.S. Treasury Department, and the Office of the U.S. Trade Representative.
With the EU’s new insurance regulatory regime, Solvency II, set to go into effect in January, the clock on negotiations has already been ticking for some time. The EU is eager to talk, as evidenced by the European Council’s April 2015 authorization by the European Commission to begin negotiations.
Solvency II matters because U.S. officials want the EU to grant the U.S. insurance regulatory system “equivalence” with the EU in areas that include the provision of policyholder and beneficiary protection and supervisory cooperation. If the EU does not grant equivalence, U.S.-based insurers operating in the EU may be subject to extra requirements, such as on reporting and collateral, and possibly structural changes. That would make U.S.-based insurers less competitive overseas.
Key Points of Negotiations
In May 2015, the European Commission decided to grant provisional equivalence to the United States for group solvency calculation, which measures whether an insurance group is adequately capitalized. Provisional equivalence is good for 10 years and is renewable by the EU.
The EU has yet to grant equivalence in two areas:
In the United States, state insurance departments still regulate most of the business of insurance, with each state commissioner overseeing the operations of subsidiary companies in his or her state. The EU is concerned that states do not have the means or incentives to adequately supervise the larger, more complex financial groups of which these subsidiaries are a part. The results of inadequate supervision can be costly. In the case of AIG prior to the financial crisis, the actions of a single division, AIG Financial Products, may have taken down the entire company absent a federal bailout.
The National Association of Insurance Commissioners (NAIC), the group that represents U.S. state insurance regulators, argues that its “windows and walls” approach can effectively give state regulators “windows” to look at group activity and the ability to “wall” off insurance capital from the rest of any non-insurance activities of a group.
The EU wants to remove state-level collateral requirements for EU reinsurers. Historically, reinsurers based outside the United States have been required to post 100 percent collateral in the United States for loss reserves associated with the risks they reinsure from U.S.-based insurers. US-based reinsurers have been exempt from this requirement.
Many outside the United States see the current collateral requirements as a way to give U.S.-based reinsurers an unfair competitive advantage. The NAIC and others have argued that collateral requirements exist to ensure assets are available domestically to promptly pay claims to U.S. policyholders and protect the solvency of U.S.-based insurers that buy reinsurance. The NAIC has further said that a covered agreement is unnecessary given progress states have made in reducing the burden on foreign reinsurers.
The EU could grant equivalence to the United States in one or both areas, either indefinitely or on a temporary basis. Temporary equivalence would be granted for five years and would not be renewable. The outcome will depend on whether the EU finds important differences in the U.S. regulatory structure compared to Solvency II to be acceptable or whether the EU will demand changes before granting equivalence.
The United States plans to also address the sharing of confidential regulatory data and gain permanent equivalency for group solvency calculation in the covered agreement.
More detail about equivalence under Solvency II can be found here.
As mentioned, a covered agreement can preempt state regulatory provisions only if foreign-based insurers are treated less favorably than those based in the United States. So, for example, a provision on reinsurance collateral in a covered agreement would likely reference that U.S.-based reinsurers are not subject to the collateral requirements that foreign-based reinsurers are.
It seems unlikely that the two sides will come to an agreement before Solvency II goes into effect on January 1. If they do reach an agreement, it may include one or more provisions that would effectively be a federal preemption of state insurance regulation. Given that most of the industry was overseen exclusively by the states prior to passage of the Dodd-Frank Act, that would indeed be a milestone.