The Federal Reserve Board has taken a big step toward proposing its first-ever capital requirements for the insurance companies it supervises. On Friday, the Fed approved an advance notice of proposed rulemaking on how to approach capital requirements for the 14 insurance companies that the Dodd-Frank Act put within its jurisdiction.
The Fed is sending three important messages with its proposal:
- It understands that insurance is different from banking.
- It understands that systemically important insurers are different from the other insurers it supervises.
- It is not afraid to use a different approach to insurance solvency regulation than other countries when it makes sense for the United States.
The advance notice invites the public to comment on the Fed’s ideas for applying capital standards to 14 insurance companies, which include two (AIG and Prudential) that were designated by the Financial Stability Oversight Council (FSOC) as systemically important financial institutions, or SIFIs. The other 12 are insurance companies that own a savings and loan (a depository institution similar to a bank), and are organized as savings and loan holding companies. Together, these 14 companies account for about a quarter of the U.S. insurance industry’s assets. (In late March, a federal judge ruled in favor of MetLife in a lawsuit against FSOC and removed the company’s SIFI status. The case is being appealed by the government.)
The Fed indicated that having insurance capital standards in place prior to the crisis would have given regulators a better window into what AIG was doing and helped them to prevent its collapse.
Congress embedded within the Dodd-Frank Act a lesson from the financial crisis that it was not enough to ensure the safety and soundness of individual financial institutions. There needed to be a body responsible for monitoring and addressing systemic risk, or the risk that could be posed to the financial system as a whole from shocks to the real economy and/or one or more financial institutions. Insurance companies had been regulated almost exclusively by state insurance departments until Dodd-Frank, which created FSOC’s designation authority and moved oversight of savings and loan holding companies from the now-defunct Office of Thrift Supervision to the Fed. The logic was that, while traditional insurance activities were not the source of the most recent financial crisis, the highly risky activities pursued by insurance giant AIG’s Financial Products Division led to massive losses that required a government bailout in 2008 to avoid a collapse of the broader financial system. Accordingly, insurers owning depository institutions and systemically important insurers would require closer supervision and stronger capital cushions.
In fact, at last Friday’s meeting to discuss the advance notice, Fed staff said that having insurance capital and other prudential standards in place prior to the crisis would have given regulators a better window into what AIG was doing and helped them to prevent its collapse.
State insurance departments are still the primary regulators for insurers, but insurance companies operating in multiple states and countries generally do so through separate subsidiaries in each jurisdiction. Each state regulator is responsible for the subsidiary domiciled in its own state. No single state regulator can easily gain a consolidated view of all of the subsidiaries of an insurance group, or require action of subsidiaries in other states when it sees a problem with the insurance group.
What the Fed brings to the table is its ability to look across all of an insurer’s subsidiaries, including those in other countries, and view the company on a consolidated basis. This allows the Fed to have a better understanding of possible systemic risk that an insurer might present, and to ensure that the group is well-capitalized.
The Fed’s Proposal
The advance notice is not a proposed rule, but rather represents the Fed’s current thinking about a proposed rule. The Fed currently envisions a two-tiered set of capital standards. Option one is a building block approach, which would apply to savings and loan holding company insurers. Roughly speaking, the Fed would set capital requirements for the insurance group as the sum of the capital requirements of the group’s subsidiaries. For insurance subsidiaries, these requirements would be set by state and foreign regulators, so extra reporting requirements would be relatively light. But the building block approach would give the Fed a way to conduct group supervision.
Option two is a consolidated approach, which would apply only to insurance SIFIs. It would categorize insurance assets, liabilities, and certain other exposures by risk; apply risk factors to each category; and use them to determine how much capital should be required for the consolidated group. In short, as with banks, riskier assets and liabilities would trigger higher capital requirements, and the capital counted towards these requirements would also meet certain quality standards. This approach would permit the Fed to set a capital requirement for the company as a whole, rather than for each subsidiary individually.
One question the advance notice does not ask is the potential competitive impacts of having two different capital regimes for SIFIs and non-SIFIs.
The Fed lists several pros and cons for each approach, and is seeking public comment on how it should weigh these factors, and whether it should consider alternate approaches as it develops its proposed rule.
One question the advance notice does not ask is the potential competitive impacts of having two different capital regimes for SIFIs and non-SIFIs. This issue, however, goes beyond capital standards. Congress clearly intended for additional prudential requirements—which includes capital—to apply to SIFIs. The Fed must impose these requirements on SIFIs and the agency is right to do approach them in a way that is tailored to the business of insurance. The question is more whether the SIFI designation process is the best way to address systemic risk arising from nonbanks. As I have argued elsewhere, an approach that targets risky activities and products would be preferable to one that targets individual firms.
We believe the Fed is sending three clear signals with the advance notice, and with a speech made in May by Federal Reserve Board Governor Daniel Tarullo to preview it.
Insurance is different from banking
As BPC outlined in our 2015 issue brief, the businesses of insurance and banking share similarities but also important differences. For example, banks are susceptible to runs on deposits and other short-term debt that can lead to sudden failure. In contrast, traditional insurance activities generally are not vulnerable to liability runs, but instead can fail when they misjudge the risks they are insuring or make bad investments with premiums they collect. When they fail, banks are resolved quickly, often over a weekend, to ensure continuity of service and avoid the risk of depositor panic spreading to other financial institutions. When insurers fail, the resolution process can take years or decades, since policyholders of the failed company must trigger a claim to collect on the insurer’s obligations to them.
Some policymakers and industry representatives have been skeptical that the Fed’s long-standing, bank-centric culture could be adapted for insurance regulation.
Fed officials have been saying the right things about understanding the difference between insurers and banks for the past few years. Still, some policymakers and industry representatives have been skeptical that the Fed’s long-standing, bank-centric culture would allow them to follow through on their words. The advance notice is a concrete indication that the Fed is attempting to do so.
The advance notice says the Fed hopes to draft capital standards for insurers that are “consistent with the Board’s supervisory objectives and appropriately tailored to the business of insurance.” In fact, tailoring is a strong theme throughout the 28-page document, which uses some version of the word “tailor” 13 times and a version of the word “appropriate” 30 times.
SIFI insurers are different from SLHC insurers
The smallest of the 14 insurance companies the Fed regulates has about $3 billion in total assets while the largest has about $700 billion. The 14 firms also vary substantially in their structures, activities, accounting practices, complexity, and global footprints. The Fed made clear that it realizes that it would not make sense to regulate them all in the same way. To that end, the building block and consolidated approaches are two different ways to approach group supervision that are tailored to the differences between SIFI and savings and loan holding company insurers.
The Fed is not afraid to use a different approach to insurance solvency regulation than other countries
At Friday’s meeting, the discussion several times contrasted the Fed’s current thinking with how insurance regulation is being handled in Europe and in discussions with global regulators. The advance notice states that, “the capital framework also should be based on U.S. regulatory and accounting standards and not foreign regulatory and accounting standards in order to best meet the needs of the U.S. financial system and insurance markets.”
Fed Governor Tarullo provided more detail on these contrasts in his speech last month, saying, for example, that progress in developing an international insurance capital standard “has been slow.” He cited specific difficulties in agreeing with global regulators how to treat savings and retirement products that are common in the United States and less so elsewhere, differences in accounting standards, and a disagreement over how much to rely on insurers’ own internal models in assessing their compliance with capital standards.
Tarullo also raised concerns with Solvency II, the European Union’s new comprehensive insurance regulatory framework. He argued that Solvency II’s methods of valuing insurance liabilities would lead to more volatility than the U.S. approach, and that the European framework also relies too much on firms’ internal models.
We think these points, which were also reflected in the advance notice, are generally correct and the Fed is wise to incorporate them into its proposal.
The window for public comments on the advance notice is open for 60 days, until August 2. The Fed will then consider those comments and formulate a more details proposed rule for insurance capital standards. A final rule is likely many months down the road, but the advance notice represents a good conceptual first step to getting there.