How FSOC Undermined, and the Fed May Save, U.S. Case for Insurance Regulatory Equivalence

Later this year, European Union officials will make several decisions whether to grant U.S. insurance regulation “equivalence” with the EU’s new insurance regulatory and capital regime set to take effect in January. Equivalence would make doing business easier for insurers and regulators on both sides of the Atlantic. A decision against equivalence could complicate economic relations between the United States and the EU, or even upset the Transatlantic Trade and Investment Partnership (TTIP) talks toward freer trade and investment between the two large economic blocs.

It is interesting, then, that the Financial Stability Oversight Council (FSOC) may have undermined the U.S. case for equivalence in the supervision of insurance groups as part of its designation of MetLife as a systemically important financial institution (SIFI). FSOC’s rationale for designating MetLife appears to validate European concerns that the United States lacks effective group supervision for insurance that is comparable to its own. At the same time, the Federal Reserve’s (Fed) new regulatory regime for insurance companies might provide the solution, one that would effectively cement the new federal role in U.S. insurance regulation that was launched in, and as a result of, the Dodd-Frank Act.

Solvency II and Equivalence

On Jan. 1, 2016, the European Union will implement Solvency II, its new risk-based insurance regulatory and capital regime. Solvency II was created with the goal of developing a single EU insurance market by harmonizing insurance regulation across member countries.

As part of Solvency II, EU officials will have to decide whether other countries’ insurance regulatory regimes are equivalent to the EU’s in providing a similar level of policyholder and beneficiary protection. If the United States is granted equivalence, U.S.-based insurers could operate in the EU without having to comply with all EU rules, making them more competitive in Europe.

Equivalence can be granted in three areas:

• Group supervision: whether an insurance group and its subsidiaries are adequately supervised
• Group solvency calculation: whether an insurance group (a holding company of which the insurance company is a part) is adequately capitalized
• Reinsurance: whether a country’s supervision and solvency regime for reinsurance companies is adequate

On June 5, the European Commission announced that the United States was one of six countries to receive “provisional equivalence” for 10 years for group solvency calculation. This provisional equivalence is indefinitely renewable by the EU and is not a pressing issue.

The EU can grant temporary equivalence in group supervision and reinsurance for up to five years. If granted, this temporary equivalence would not be renewable. If the United States is granted equivalence in group supervision, it would mean that U.S.-based insurers operating in the EU would be exempt from some of the EU’s group supervisory requirements and may avoid having to make structural and operational changes.

Concerns about Group Supervision

Group supervision of U.S. insurers has been a significant issue for European regulators. Prior to the Dodd-Frank Act, insurance regulation and supervision was handled entirely by states. Foreign regulators, however, have been concerned that while states have a good record of protecting policyholders and ensuring the solvency of insurance subsidiaries in their own states, those states lack the authority and incentive to monitor the activities of insurance groups and the risks they might pose to broader financial stability.

Concerns about group supervision by states in the U.S. are reflected in the “Way Forward” document agreed to by EU and U.S. officials—specifically, the Federal Insurance Office (FIO) and National Association of Insurance Commissioners (NAIC)—in January 2012 to better coordinate insurance oversight. State insurance regulators have been working to respond to these and other concerns.

In 2008, the NAIC began its Solvency Modernization Initiative (SMI) to address group capitalization and supervision, among other issues. The NAIC has adopted model legislation to improve group supervision, including the Insurance Holding Company System Model Act, which gives state regulators the authority to supervise insurance groups. The NAIC has argued that its “windows and walls” approach can effectively give 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.

In 2014, the State of New Jersey went further, passing legislation that authorizes the New Jersey Commissioner of Banking and Insurance to be the group-wide supervisor for internationally active insurance groups (IAIGs) headquartered in that state. It even gives the commissioner the authority to act as a group supervisor for IAIGs with substantial operations in New Jersey but headquartered in other states, under certain conditions. However, it is unclear exactly how New Jersey could actually regulate the behavior of subsidiaries in other states or how insurance regulators in other states would respond to New Jersey attempting to exert its authority.

The 2015 International Monetary Fund’s (IMF) assessment of U.S. insurance regulation reported that states were making progress under SMI but that changes are “a work in progress” that still face obstacles. EU officials will need to determine whether progress by states so far will be enough to grant equivalence to the United States on group supervision. The Federal Insurance Office (FIO) and the U.S. Trade Representative have the authority to negotiate a “covered agreement” with the EU on certain insurance matters, which may include group supervision.

FSOC Rebuts State Regulators

The context for these negotiations will likely be informed in part by the case FSOC has made against the ability of states to engage in adequate group supervision.

In its December 2014 designation of MetLife as a SIFI, FSOC explicitly said that the company “is currently not subject to consolidated supervision,” and that state insurance regulators lack the authority to require insurance holding companies or other subsidiaries of holding companies to take or not take actions to preserve the safety and soundness of insurers or to avoid risks that would threaten U.S. financial stability. Further, FSOC said that state regulators’ authorities, “have never been tested by the material financial distress of an insurance company of the size, scope, and complexity of MetLife’s insurance subsidiaries.”

FSOC’s arguments, perhaps inadvertently, effectively undermine the NAIC’s case that its “windows and walls” approach is sufficient. Since FSOC’s designation represents the views of all U.S. federal financial regulators, this makes it more difficult for the U.S. government to argue on behalf of a temporary or permanent granting of equivalence.

Enter the Fed

Dodd-Frank gave FSOC the authority to designate nonbank financial companies as SIFIs and subject them to oversight by the Fed. Three of FSOC’s four designations have been insurers: AIG, Prudential, and MetLife. In addition, Dodd-Frank gave the Fed oversight of savings and loan holding companies, which includes 14 holding companies that operate significant insurance companies. A major question remains: How much will the Fed exercise its new authority?

Last month, Federal Reserve Board Senior Advisor Thomas Sullivan, who has been identified as the Fed’s point person on insurance matters, said at an Institute of International Finance conference that the agency sees its role as complementary to state oversight, not duplicative. He also said the Fed would focus on group supervision and financial stability rather than on the kind of supervision and regulation of individual insurers that states have been doing for decades. Indeed, the Fed’s roughly 70 employees who work to one degree or another on insurance could not duplicate the supervisory and regulatory activities of about 12,000 employees of state insurance regulators and the NAIC.

Taken together, FSOC and the Fed are in effect saying that states are either unable or ill-suited to deal with supervision of insurance groups and the risks they might pose to U.S. financial stability, but that the Fed can and will fill these gaps. Since foreign regulators generally view the Fed’s increased role in group supervision as a positive—the IMF’s 2015 assessment said that the Fed’s new group supervisory role “has strengthened supervision”—this amounts to an argument for U.S. equivalence on group supervision. Ironically, if the EU accepts this line of argument, it would likely cement the new federal role in insurance oversight in the long run.