Fed Envisions a Lighter Touch for Insurance Requirements

WASHINGTON — The Federal Reserve's proposals to set prudential and capital rules for insurance companies designated as systemically risky and smaller insurers with depository affiliates are sending a simple message: We can be tough, but fair.

During a board meeting Friday, Vice Chairman Stanley Fischer pointedly asked whether the prudential standards being proposed would have kept AIG from the brink of insolvency during the financial crisis.

"If the general framework for insurance companies had been in place just before late August 2008, would they have prevented the [liquidity crunch] at AIG?" Fischer asked.

Thomas Sullivan, associate director of the Fed's division of banking supervision and regulation, replied that the "combination of the two proposals before you would have addressed the risks and the stress that was confronted by AIG at the time of the crisis."

But the Fed also made careful distinctions in its plans. Mark Van Der Weide, deputy director of the Fed's division of banking supervision and regulation, said the capital and prudential regimes outlined do not contemplate many of the quantitative liquidity rules, such as the liquidity coverage ratio and net stable funding ratio, that the agency has required for banks.

"We've spent a lot of time thinking about whether it makes sense to do some kind of liquidity rule, for the systemically important firms in particular," Van Der Weide said. "To the extent we do want to do something like that, it will clearly be far different form a cut-and-paste of the LCR and the NSFR, because of the very different nature of insurance company liabilities."

Van Der Weide added that when the Fed moves forward with other required macroprudential rules for the systemically designated insurance firms, such as stress testing single counterparty credit limits, it will be more thoughtful than simply applying the same rules to insurance firms.

"We've been working relatively concurrently on the capital rule and the stress testing framework," Van Der Weide said. "Establishing the capital rule is more or less a condition precedent of establishing the stress testing requirement — stress testing is an assessment of whether the firm can stay above the minimum capital levels in the stress period. But intellectually we are developing them at the same time."

The Fed issued two proposals on Friday. The first is a proposal outlining prudential standards for insurance firms designated as systemically important financial institutions by the Financial Stability Oversight Council — a distinction currently shared only by American International Group and Prudential. MetLife was designated in December 2014 but challenged its designation in court, winning its case in February (the FSOC has said it will appeal).

Fed staff described the prudential standards as effectively "best practices" for risk and liquidity preparedness, and the proposal estimated that the costs associated with compliance "are not expected to be material within the context of the institutions' existing budgets."

The Fed also issued an advance notice of proposed rulemaking outlining the basic framework of its capital standards for both insurance SIFIs and smaller firms that have depository institutions among their affiliates and are therefore subject to Fed oversight.

The capital plan — which hews closely to an outline delivered by Fed Gov. Daniel Tarullo May 20 in a speech before state insurance regulators — envisions a "consolidated approach" to regulating capital at the insurance SIFIs. Under that framework, a firm's consolidated assets and liabilities would be assigned to different categories and assigned risk levels accordingly. What those categories might be and how risky they are thought to be was not specified in the publication.

For smaller insurance firms — the proposal said there are currently 12 that would be affected — a "building-block" approach would be used, whereby each of the firms' component entities would have to be capitalized at the level required by their individual regulator. This would effectively preserve the states' preeminence in regulating insurance firms while preserving bank regulators' prerogative to require capital standards.

Mike Krimminger, former general counsel at the Federal Deposit Insurance Corp. and partner at Cleary Gottlieb, said in an interview early Friday that the specifics of how the Fed regulates insurance firms could have implications for the arguments against — or in favor of — the FSOC designation concept in general. Opponents of the FSOC designation process have repeatedly said that designation enshrines firms as too big to fail, he said, and how harshly the Fed comes down on those firms could go a long way toward countering that perception.

"The political argument that this somehow favors companies — I don't think it does at all," Krimminger said. "From a perspective of smaller institutions, this is kind of balancing out the perceived 'too big to fail' status of the larger companies, which we demonstrated was more than a perception in 2008."

Justin Schardin, acting director of the Financial Regulatory Reform Initiative at the Bipartisan Policy Center, said the proposals show that the Fed understands the differences between banks and insurance companies, the difference between insurance companies under its jurisdiction, and the importance of jettisoning international agreements that don't work for U.S. firms.

On that last point, Schardin noted that some had been concerned that an EU-based convention called Solvency 2 — which relies on international rather than U.S.- based accounting practices — would prevail, thus requiring firms to assign market prices to their assets even in cases where they had no intention to sell. That seemingly small difference could actually exacerbate a crisis by making firms seem to have lower asset values than they actually do, and the decision not to follow that directive shows that the Fed is not blindly lock step with international agreements, Schardin said.

"There are a lot of members of Congress who have been worried that the Fed may sell out the insurance regulation for things that they want in banking regulation," Schardin said. "I think they're signaling clearly that [they] will diverge from our international partners when it makes sense."

The proposals also send an important signal to insurance firms who maintain depository institutions among their affiliates — smaller firms who had feared an aggressive Fed would make it harder to maintain those affiliates.

Karen Shaw Petrou, managing partner at Federal Financial Analytics, said that by effectively proposing to maintain the status quo, the Fed may in fact encourage insurers to get into the banking business — and that could be good news for small and midsized banks looking for a buyer.

"I think that one of the takeaways from the non-SIFI framework is that, depending on how the final risk weightings are constructed, a major barrier to a new round of integration between banking and insurance will drop," Petrou said. "This might be one of the most significant franchise value benefits for smaller and midsized insured depositories … in the last eight years."

Schardin said that at the very least, it will stop the flow of insurers selling their banking affiliates out of fear of the Fed's heavy hand. Allstate sold its bank deposits to Discover Bank in 2011, and MetLife sold its bank deposits to GE Capital in 2013 (which has since sold its deposits to Goldman Sachs).

"The ideal is that, to the extent that owning a thrift allows you to better serve your customers, that should be the deciding factor," Schardin said. "I'm speculating that the Fed would like for that to be a business decision more than anything. It may take away a disincentive to own one, but it will depend on the details."

After the proposals were released, Prudential said in a statement that it was "pleased to see the progress" demonstrated in the proposal, particularly as it seems to be "a positive step forward that recognizes the underlying economics of our businesses."

The firm added that it is "evaluating the proposals" and looks forward to "continuing to participate in the ongoing dialogue about international and domestic supervisory matters with our regulators."

An AIG spokesman said the firm would decline to comment.

Sen. Sherrod Brown, the top Democrat on the Senate Banking Committee, also praised the proposals' distinction between larger, riskier firms and others under its jurisdiction.

"I welcome the Federal Reserve's deliberate and thorough approach in tailoring capital and liquidity rules to insurance companies in order to protect taxpayers and our economy from another AIG disaster, without treating all insurance companies the same," Brown said. "The Fed's proposal is a step in the right direction, and I will play close attention to the rulemaking process as it moves forward."