The recent economic crisis shined a spotlight on financial services companies and their regulation, culminating in 2010 with the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank” or the “Act”). Despite the central role that AIG played in the crisis, insurers emerged from the legislative process and initial regulatory implementation relatively untouched, as Congress and the federal agencies focused on the banking industry. In 2013, however, insurers started to feel the effects of the continuing focus on financial stability, both here and abroad. 2014 will bring more of the same, as insurance company regulation, receivership and resolution issues will loom large on the federal and international stages. Here is a quick rundown on some of the recent developments.
Federal Insurance Office (FIO)
On December 12, 2013, FIO released the long anticipated report on insurance modernization. The report is thoughtful and well-written. It should translate nicely to the big screen, possibly with Justin Timberlake starring as Director McRaith.
The report is divided into five parts: (1) an introduction with a summary of recommendations for modernizing insurance regulations in the United States; (2) the history of insurance regulation in the United States; (3) an analysis underlying the recommendations regarding prudential oversight; (4) an analysis supporting the recommendations concerning marketplace oversight; and (5) principles of regulatory reform as it affects insurance.
FIO was careful to note that this was the beginning of a longer examination/discussion process, with federal flags planted in a whole spectrum of subject areas. Every page contains fodder for regulator, industry and Congressional inquiry. The spotlight is on state regulation and will stay there. Director McRaith sums it up this way:
The report reflects an extensive study of the insurance sector and benefits from the collective expertise and experience of state, federal and international supervisors. It also recommends a hybrid approach to insurance regulation that provides a practical, fact-based roadmap to modernize and improve the U.S. system of insurance regulation. Importantly, this report reflects the dynamic nature of the regulatory system for insurers and provides an explicit path for state and federal regulatory entities to calibrate involvement going forward. We look forward to continuing our work with all stake holders as the United States moves forward with modernizing insurance regulation.
Here are some of the report’s main points with respect to capital adequacy and safety/soundness.
- A domestic regulator should not have discretion to allow an insurer to deviate from accounting or capital standards without the consent of regulators from other states where the insurer operates.We need greater consistency and uniformity, and state-by-state discretion runs counter to those goals.
- States should move forward cautiously with the implementation of principles-based reserving and condition.Very cautiously.
- The NAIC’s accreditation program should use an independent, third-party reviewer.No word yet on who the reviewer should be, but our money is on Hillary.
- States should develop a uniform and transparent solvency oversight regime for the transfer of risk to reinsurance captives.There’s a lot of beef in this section, and we expect more from FIO regarding captives in the coming months.
- The federal government should establish standards and oversight responsibility for mortgage insurers.Federal regulation is needed because “[r]obust national solvency and business practice standards, with uniform implementation, for mortgage insurers would help foster greater confidence in the solvency and performance of housing finance.”
- In the absence of direct federal authority over an insurance group holding company, states should continue to develop approaches to group supervision and address the shortcomings of solo entity supervision.
- Supervisory colleges are good, and FIO wants to participate.Early and often.
The report includes suggestions regarding receiverships, including with respect to closing and netting out of derivatives and other qualified financial contracts and reporting of receivers’ administrative expenses. It also includes observations about the uniformity of receivership laws and how receivership decisions are made. The report does not suggest that the federal government might have a role in improving the state receivership system.
There also is a two-page section on the guaranty system, and the system fares pretty well. The report suggests that state guaranty associations “should enact uniform policyholder recovery rules so that all policyholders, irrespective of where they reside, receive the same benefits” from guaranty associations. With respect to the guaranty system’s financial capacity, the report recommends that the system periodically model the failure of large insurance groups and have the work reviewed by FIO.
Don’t be surprised if FIO follows-up on every one of its recommendations. This report was not written to gather dust on the shelf.
Federal Deposit Insurance Corporation (FDIC)
Title II of Dodd-Frank creates a new resolution mechanism for liquidating systemically important financial institutions (“SIFIs”) that the federal government determines are in default (or in danger of default) and whose failure would have serious adverse effects on the U.S. economy. While the FDIC will be appointed receiver of most such entities, all insolvent insurance companies will remain subject to state receivership and guaranty fund processes.
But don’t assume that the FDIC’s expanded powers would be irrelevant for purposes of resolving a mega insurance insolvency. To the contrary, the FDIC’s single point of entry receivership strategy for resolving SIFIs shows that just the opposite is true. (The strategy was announced in 2012 in a presentation by the Office of Complex Financial Institutions and a speech by then Acting Chairman Gruenberg. It was formalized in a request for comments published on December 18, 2013.) Among other things, the FDIC’s strategy entails (i) placing a troubled SIFI into receivership at the parent company level, (ii) moving the SIFI’s operating subsidiaries (and other assets) to a newly capitalized bridge entity, and (iii) continuing the operations of such subsidiaries, with liquidity support (if needed) provided by the bridge entity, the private markets or the orderly liquidation fund established by Dodd-Frank. Claims of the parent company’s unsecured creditors and equity holders would remain with the receivership and would be satisfied with debt and equity securities to be issued by the bridge entity. Any insolvent operating subsidiary that could not be recapitalized would be placed into a separate receivership under the federal bankruptcy code or other applicable law.
Under the FDIC’s approach, if a troubled SIFI owned an insurance company, the parent company would be placed into a Title II receivership, and the insurance company would be moved underneath a bridge entity. If the insurance company was experiencing cash flow problems, the best case scenario is that the FDIC’s strategy could provide liquidity and avoid the need for a state receivership proceeding and guaranty fund involvement. Even if the insurer turned out to be insolvent and could not be saved, the FDIC’s strategy could buy valuable time for the receiver and guaranty funds to exchange information and coordinate a resolution plan.
The single point of entry receivership model has certain challenges that are noted in the FDIC’s request for comments. (Among other things, the model depends on the parent company having enough unsecured debt and capital to absorb losses, recapitalize operating subs and allow for formation of the bridge entity.) Making the model work for an insurance SIFI would require significant communication and coordination among the FDIC, state regulators and the guaranty system. In addition, mutual insurance companies would pose a special challenge because they don’t have non-operating holding companies at the top of their organizational structure. Nevertheless, we think the FDIC’s strategy has a lot of merit and is worth pursuing.
Federal Reserve Board (Fed)
In a speech last October, Governor Tarullo of the Federal Reserve Board observed that “[i]n many ways, Title II has become a model resolution regime for the international community.” He also said that the “FDIC's work on the single-point-of-entry approach continues to help frame the terms of international discussions” at the Financial Stability Board. Neither observation is surprising, given the significant weight that the U.S. carries internationally, including at the FSB.
The Fed’s global influence is increasingly relevant for insurers. When the Financial Stability Oversight Council designated AIG and Prudential as systemically important in the latter half of 2013, the Fed officially became an insurance regulator. After that, the Fed wasted no time in seeking membership in the International Association of Insurance Supervisors, and it now is a provisional member. (There were conflicting reports as to whether the Fed was seeking a spot on the important IAIS Executive Committee.) By influencing international insurance regulation through the FSB and IAIS, the Fed can extend its reach far beyond AIG, Prudential and any other insurer designated a SIFI by FSOC. Not that we’re paranoid.
Financial Stability Board (FSB)
Established in April 2009 by the G-20, the FSB develops and promotes the implementation of effective regulatory, supervisory and other financial sector policies aimed at financial stability. The U.S. members of the FSB are the Federal Reserve, Treasury and the SEC.
As part of its responsibilities, the FSB, in July 2013, named nine companies as globally systemically important insurers (GSIIs), which will be subject to recovery and resolution planning requirements, enhanced group supervision and higher loss absorbency (HLA) requirements. We understand that the FSB may be considering reinsurers that could be named as GSIIs in July 2014.
The FSB’s activities affect more than just specific companies; they also impact how receiverships will be conducted. In 2011, the FSB adopted something called the “Key Attributes of Effective Resolution Regimes for Financial Institutions,” which the G-20 subsequently endorsed as the international standard for resolution regimes. The Key Attributes set out the core elements necessary to resolve financial institutions without causing severe systemic disruption and without exposing taxpayers to loss. They require resolution authorities to have powers very similar to those granted the FDIC under Dodd-Frank and are a “must have” for FSB-member countries that seek to comply with international standards.
The FSB issued a consultative paper on August 12, 2013 that describes how the Key Attributes would apply in the context of systemically significant insurance resolutions. The FSB issued another consultative paper on August 28, 2013describing its methodology for assessing whether member countries have complied with the Key Attributes.
In our view, the U.S. state-based receivership/guaranty system stacks up pretty well against the Key Attributes, when it is combined with the FDIC’s single point of entry resolution strategy. The good news is that the FSB’s Key Attributes expressly contemplate that multiple authorities may share responsibility under a resolution regime.
One more item of note on the FSB front: on August 27, 2013, the FSB issued itspeer review of the U.S. system of insurance supervision. While recognizing that the states have made significant progress, the peer review states that “[t]he US authorities should promote greater regulatory uniformity in the insurance sector, including by conferring additional powers and resources at the federal level where necessary,” a theme echoed in the subsequently-released FIO modernization report described above.
International Association of Insurance Supervisors (IAIS)
The flurry of activity at the FSB has impacted the IAIS in a big way. Historically, the IAIS has been the FSB’s authority on insurance matters. Recently, however, the FSB has appeared to be less interested in deferring to the IAIS and more interested in dictating what the IAIS should do. State regulators noted this trend at the NAIC meeting in August 2013 and expressed significant concern.
Consistent with fears that the IAIS is being directed by bank centric regulators, most of the action at the IAIS annual meeting in Taiwan in October 2013 and thereafter has focused on insurance capital standards for both internationally active insurance groups (IAIGs) and global systemically important insurers (GSIIs). These capital standards are intended to promote financial stability.
- GSIIs:On December 16, 2013, the IAIS released a public consultation document on basic capital requirements (BCRs) applicable to GSIIs. This is the first of two planned public consultations and will inform the design of field testing of the BCR, which is scheduled to commence in March 2014 with a group of volunteer companies. The second consultation is scheduled to commence in July 2014, after field testing, and will provide an opportunity for comments on more specific BCR proposals. The BCRs, scheduled to be implemented in late 2014, purportedly will serve as the foundation for GSII HLA requirements. (It is yet to be determined whether the BCRs will apply to IAIGs. See below.) HLAs are expected to be finalized by the end of 2015 and will be effective in 2019.
- IAIGs:An IAIG is a large internationally active group that includes at least one sizable insurance entity. Under current proposals, a group would be an IAIG if (1) premiums are written in at least 3 jurisdictions and at least 10% of the group’s total gross written premium is written outside of its home country and (2) the group has total assets of at least $50 billion or gross written premiums of at least $10 billion. In October 2013, the IAIS announced that it will develop a risk based global insurance capital standards by the end of 2016, with full implementation beginning in 2019.
In October 2013, the IAIS published an “Issues Paper on Policyholder Protection Schemes,” which is just one of several papers published over the last few years focusing on insurance safety nets. In spite of the fact that the global insurance industry fared relatively well during the economic downturn, interest in existing and proposed insurance safety nets has increased. For example, in 2010, the European Union initiated the process to ensure that all member states have a policyholder protection scheme that complies with a minimum set of design requirements. The European Commission (one of the two EU legislative bodies) was expected to come forth with a proposed directive by the end of 2012 or beginning of 2013, but that has yet to materialize. As more countries consider establishing policyholder protections schemes, knowledge about existing schemes is in more demand. The IAIS paper responds to that demand by providing a survey of the structures and practices of policyholder protection schemes around the world.
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There’s a lot here to digest, and most of the developments are connected in some way. Insurers who want to help shape the future of regulation will need to monitor events closely and stay engaged with key policy and decision makers.