Shortcomings seen in U.S. nonbank systemic-risk process for insurers

April 21, 2015

Critics of the the Financial Stability Oversight Council’s designation of nonbanks as systemically important got a chance last month to point to what they viewed as shortcomings in its approach, while also offering clues for possible improvements, during a U.S. Senate hearing on the issue. 

Ever since its creation under the 2010 Dodd-Frank Act, the process by which the council designates systemically important financial institutions, or SIFIs, has been criticized as being heavily politicized, and marred with opacity.

FSOC, its rationale, and designation process 

The FSOC was created by the Congress in the wake of the financial crisis as an early warning mechanism, with the intention to detect and designate systemically important institutions and risk areas. This was clearly an effort to preemptively contain possible spillover effects into other areas of the financial sector.

The council implements a three-stage process of screening and evaluation, where companies potentially subject to designation are measured against specific thresholds based on 10 criteria in Dodd-Frank. If a company has more than $50 billion in total consolidated assets, and breaches any one of the following thresholds, it is identified for more analysis under a second stage.

• $30 billion in gross notational credit default swaps outstanding for which a non-financial company is the reference entity

• $3.5 billion of derivative liabilities

• $20 billion in total debt outstanding

• 15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity

• 10 percent short-term debt ratio of total debt outstanding with a maturity of less than 12 months of total consolidated assets (excluding separate accounts)

In stage two, company data is analyzed in greater depth –with the help of the Office of Financial Research– within the framework of its interconnectedness, size, leverage, substitutability, liquidity risk and maturity mismatch, and existing regulatory scrutiny.

A third stage entails further evaluation of internal assessments, internal risk management procedures, funding details, counterparty exposure, position data, strategic plans, resolvability, potential acquisitions or dispositions. The council votes on whether to designate a firm as systemically important.

The company may object to the designation within a month before it is finalized — to date no firm has successful in overturning a designation as a systemically important financial institution.

Unsurprisingly, no company wants to be designated, as the designation comes with a high regulatory price tag. It includes such requirements, among others, as credit exposure limits, debt-to-equity ratio ratio, stress testing, early remediation, increased capital, a “living will” in the event that the company fails, and increased reporting.

On the face of it, the process based on hard-wired numbers, and seems to be impartial.

However, as seen by some in the financial industry there are a number of shortcomings underlying the process, specifically, with regards to the designation of insurance companies.

Shortcomings underlying the process 

Gary Hughes, the executive vice president and general counsel at the American Council of Life insurers – which represents companies that offer life insurance, annuities, reinsurance, long-term care and disability income insurance, and that make up more than 90 percent of the industry assets– has taken a particular interest in the process. No less than three out of the four nonbank financial companies that have been designated as systemically important are insurance companies, namely, Prudential, AIG, and MetLife.

Hughes’ testimony to the Senate, outlined below, voices concerns shared by others in the industry:

A “skewed” composition 

The FSOC is composed of 10 voting and five non-voting members. Of the fifteen, only three come with insurance experience, and of this three only the primary regulator of the company considered for the SIFI designation has voting rights — the state insurance commissioner, and the director of federal insurance office do not — in the designation of a SIFI. This means, it is those nine voters of the Council with little or no understanding of the insurance sector who carry an uncontested weight –even beyond the statutory two-thirds majority required for determining whether an insurance company poses systemic risk to the financial system.

To make the process fairer, more deference – for example, weighted voting right in SIFI designation — could be given to the primary regulator of the company under consideration, as he or she will happen to be the only one of the ten voting members with specific expertise in the industry. This would mean that the Council member from the Securities and Exchange Commission would have the right for a weighted vote more weight in its vote for if SIFI designation. This would similarly be the case for the independent member with insurance experience for an insurance company’s designation.

To cite an example, FSOC has shown little interest in the assessment of MetLife’s primary regulator, the New York State Department of Financial Services (NYDFS). The assessment had stated that MetLife does not engage in substantial nontraditional noninsurance activities that can be characterized as systemic risk, and that the department and other regulators are ready to ensure an orderly resolution, should the institution fail.

Additionally, the veto system could be enhanced. Currently, the Secretary of the Treasury holds unilateral veto power over any company’s designation. Such veto power granted to the Council member with specific industry experience –in banking, insurance, or asset management– could bring more balance to the designation process.

In this context, it is telling that the Council member with insurance experience has used his dissent on Prudential and MetLife SIFI designations –not on AIG. One can argue that AIG’s role in the crisis, exacerbating the systemic risk in the financial system, had made its case to be too politically charged to avoid the SIFI designation, despite significant changes in its business models.

Different industries, different yardsticks

In its assessment of insurance companies, FSOC applies the same metrics and analysis tools to insurance companies as it does to banks.

A case in point is the dissent of Roy Woodall, the independent member of the council with insurance expertise, on the designation of Prudential as a SIFI. He stressed that “the underlying analysis utilizes scenarios that are antithetical to a fundamental and seasoned understanding of the business of insurance,” and that “the analysis, in large parts, relies on nothing more than speculation.”

In replicating a bank-run-like scenario whereby most policyholders would surrender their policies, FSOC assumes, for example, an automatic trigger of a massive cash outflow, without taking into account the contractual features that allow insurers to delay payments on early withdrawals, nor the ability of regulators to impose additional stays on surrenders. It also seems to disregard the negative tax implications acting as disincentives for policyholders to surrender their policies in wholesale, or the fact that they purchase insurance policies to obtain protection — unlike bank-like products geared for investment or saving purposes.

Highlighting this difference in pay-outs, Federal Reserve Governor Daniel Tarullo, at another Senate hearing on the topic, said jokingly that “people aren’t going to die more quickly if an insurance company is in trouble.”

Another area of difference is in the nature of maturity mismatch for banks and insurance companies. While the former usually fund their long-term assets, such as loans, with short-term funding, the latter’s balance sheet typically demonstrates the opposite, i.e. long-term liabilities are matched with short-term assets, resulting in a converse interest rate and reinvestment risk.

FSOC fails to appreciate the regulatory authorities and tools available to insurance regulators, that otherwise are not to their banking counterparts — at least for the time being. Regarding the resolution process resulting from an emergency, for example, insurance regulators and the SEC can ring-fence, stemming in essence, policyholder surrenders en masse, and the resulting asset liquidation without regulatory approval. This process is a work in progress for the banks.

Lack of communication

FSOC has not been equally impartial in its approach to different segments of the nonbank financial companies. It has not had a formal engagement process with the insurance companies during the designation process. While it has met to discuss the concerns of the asset management industry, for instance, and issued a document stating that it will “undertake a more focused analysis… to assess potential risks associated with the asset management industry,” it has not offered a similar “open door policy” to the insurance companies, choosing instead to designate them directly.

FSOC has also been sparse in public pronouncements, refraining from making any announcements on whether a company is under consideration during the designation process, and has failed to provide rationale for rejecting a contested designation.

No clear “exit ramp” provided

FSOC has not provided a clear path to exit the designation, critics say. The documents supporting designations address how a company’s failure might impact financial stability, but do not address what might have caused that company to fail in the first place, leaving the company with little insight about which of its activities are to be associated with systemic risk. There were also cases where the council had simply denied insurance companies access to data and materials consulted and relied on in reaching its designation verdict. This makes it difficult for them to rebut FSOC’s assumptions, respond to its analysis and ultimately challenge the designation.

Furthermore, because the review of designations is made on an annual basis, a newly designated SIFI cannot obtain a faster review, and possible de-designation, even if it undergoes a significant change in its operations ahead of the annual cycle.

Recent changes

The FSOC has adopted changes to its designation process in February 2015, potentially allowing for some of these shortcomings to be overcome.

Going forward, the council will engage with the companies more. Steps include notification of the company when it comes under stage two review and better communication with the company’s primary regulator.

The council is also expected to provide an explanation if, in response to a company contesting its SIFI status, it refuses to rescind that company’s SIFI status at the annual review.

Capital requirement

SIFI-designated insurance companies are expected, normally, to abide by the enhanced prudential regulations –including the strict minimum capital requirements under Basel III — regardless of the fact that they operate under the statutory accounting principles that are accepted by state regulatory insurance agencies, and the Risk-Based Capital for Insurers Model Act – as adopted by the National Association of Insurance Commissioners. Regulators have promised to take into account the different business models of the insurers in tailoring the requirements within the confines of the Collins Amendment, the author of which has endorsed this approach as well in a testimony before the Senate last year.

Most critically, the Congress has recently moved to clarify that the Federal Reserve Board has the ability to base capital standards for designated insurance companies on insurance risk, rather than banking risk. The Senate followed suit and passed the Insurance Capital Clarification Act, which was then signed into law by the President.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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