[Senate Hearing 113-350]
[From the U.S. Government Publishing Office]
S. Hrg. 113-350
FINDING THE RIGHT CAPITAL REGULATIONS FOR INSURERS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
SECOND SESSION
ON
FINDING THE RIGHT CAPITAL REGULATIONS FOR INSURANCE COMPANIES UNDER THE
DODD-FRANK ACT
__________
MARCH 11, 2014
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Available at: http: //www.fdsys.gov/
______
U.S. GOVERNMENT PUBLISHING OFFICE
89-351 PDF WASHINGTON : 2015
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Publishing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800;
DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC,
Washington, DC 20402-0001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia PATRICK J. TOOMEY, Pennsylvania
JEFF MERKLEY, Oregon MARK KIRK, Illinois
KAY HAGAN, North Carolina JERRY MORAN, Kansas
JOE MANCHIN III, West Virginia TOM COBURN, Oklahoma
ELIZABETH WARREN, Massachusetts DEAN HELLER, Nevada
HEIDI HEITKAMP, North Dakota
Charles Yi, Staff Director
Gregg Richard, Republican Staff Director
Dawn Ratliff, Chief Clerk
Taylor Reed, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Financial Institutions and Consumer Protection
SHERROD BROWN, Ohio, Chairman
PATRICK J. TOOMEY, Pennsylvania, Ranking Republican Member
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York DAVID VITTER, Louisiana
ROBERT MENENDEZ, New Jersey MIKE JOHANNS, Nebraska
JON TESTER, Montana JERRY MORAN, Kansas
JEFF MERKLEY, Oregon DEAN HELLER, Nevada
KAY HAGAN, North Carolina BOB CORKER, Tennessee
ELIZABETH WARREN, Massachusetts
Graham Steele, Subcommittee Staff Director
Tonnie Wybensinger, Republican Subcommittee Staff Director
(ii)
C O N T E N T S
----------
TUESDAY, MARCH 11, 2014
Page
Opening statement of Chairman Brown.............................. 1
Opening statements, comments, or prepared statements of:
Senator Toomey............................................... 2
Senator Johanns.............................................. 3
WITNESSES
Susan M. Collins, a United States Senator from the State of Maine 4
Gina Wilson, Executive Vice President & Chief Financial Officer,
TIAA-CREF...................................................... 7
Prepared statement........................................... 29
Daniel Schwarcz, Associate Professor and Solly Robins
Distinguished Research Fellow, University of Minnesota Law
School......................................................... 9
Prepared statement........................................... 33
H. Rodgin Cohen, Senior Chairman, Sullivan & Cromwell LLP........ 11
Prepared statement........................................... 40
Aaron Klein, Director, Financial Regulatory Reform Initiative,
Bipartisan Policy Center....................................... 12
Prepared statement........................................... 49
Michael W. Mahaffey, Chief Risk Officer, Nationwide Mutual
Insurance Company.............................................. 14
Prepared statement........................................... 55
Additional Material Supplied for the Record
Letter from Senator Susan M. Collins............................. 60
Prepared statement of Sheila C. Bair, former Chair, Federal
Deposit Insurance Corporation.................................. 62
Letter from the U.S. Chamber of Commerce......................... 68
Prepared statement of William C. Hines, American Academy of
Actuaries...................................................... 70
Prepared statement of the American Council of Life Insurers
(ACLI)......................................................... 76
Prepared statement of the American Insurance Association......... 79
Prepared statement of the Property Casualty Insurers Association
of America (PCI)............................................... 86
Prepared statement of the Financial Services Roundtable.......... 89
Prepared statement of the National Association of Insurance
Commissioners (NAIC)........................................... 94
Prepared statement of the National Association of Mutual
Insurance Companies (NAMIC).................................... 96
(iii)
FINDING THE RIGHT CAPITAL REGULATIONS FOR INSURERS
----------
TUESDAY, MARCH 11, 2014
U.S. Senate, Subcommittee on Financial Institutions
and Consumer Protection,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 10:07 a.m. in room SD-538, Dirksen
Senate Office Building, Hon. Sherrod Brown, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF SENATOR SHERROD BROWN
Senator Brown. The Committee will come to order. Thank you
for joining us, especially Senator Collins, thank you for your
leadership on this issue and sharing your ideas for legislation
and advice for the Fed with the Subcommittee. Thank you for
that.
I want to first thank Chairman Johnson for permitting
Senator Toomey and me to address this important issue on our
Subcommittee and a number of others over the past 3 years.
Chairman Johnson has allowed us to examine a number of
important issues and take a more active role than
Subcommittees--at least in my understanding Subcommittees over
the years in Banking have traditionally assumed. And I
appreciate very much Tim's generosity and certainly his staff's
work with us.
I thank Senator Toomey for working with us on this hearing.
There is across the political spectrum and across party lines
broad agreement that providing traditional life and property
and casualty insurance is different from banking. I appreciate
particularly Senator Johanns' efforts on this Committee with
Senator Collins and others in fixing what we think is a very
fixable issue.
Funding sources are different for insurance and banking.
Insurers rely on customer premiums and investment proceeds. The
nature of their investments is different. Insurers must match
long-term investments with long-term policies, and the risks
are different. Insurers are concerned with natural disasters
and life events.
While I believe that traditional insurance is distinct
business from banking, institutions often combine regulated
banking and so-called shadow banking activities. Similarly
named institutions can engage in a wide range of activities
from derivatives to repo to securities lending under a range of
corporate structures. Dodd-Frank Act tried to remedy this
problem by creating the FSOC, the Financial Stability Oversight
Council, to identify systemic financial firms and encourage
regulation of risky activities. If any institution engages in
activities like securities financing transactions, those
activities should absolutely--absolutely--be subject to the
same capital rules as banks.
But I agree with New York's Banking Commissioner Ben
Lawsky, who regulates some of the Nation's largest insurers,
that applying bank capital standards to insurance is like
trying to, as he said, ``fit a square peg in a round hole.''
For that reason, it is important that the Federal Reserve
delayed applying Basel III and Section 165 prudential standards
to insurers. The Fed must determine that insurance capital
rules are appropriate under the Collins amendment. Chairman
Dodd and Senator Collins anticipated this issue. There is
nearly universal agreement that this should not require
legislation.
In 2011, Senator Johanns and I sent a letter with a group
of 20 of our colleagues representing large numbers of
colleagues in both parties agreeing that Dodd-Frank gives
regulators the flexibility to treat insurance differently. If
the Fed continues to disagree, I am committed to working with
both of my colleagues, Senator Collins and Johanns, to find a
legislative solution.
We are all concerned about creating another AIG, which
realized 45 percent of the losses of all insurers in 2008 and
received 55 percent of the Government's support provided to
insurers. Dodd-Frank contains a number of provisions to prevent
that from happening again: one, regulating derivatives to
address their credit default swap business; second, eliminating
the Office of Thrift Supervision and moving thrift regulation
to the Fed; three, creating nonbank systemically important
financial institution designations, SIFI designations; and,
last, requiring enhanced capital and leverage rules for nonbank
SIFIs.
Legislation would not alter these provisions. It would
address a narrow, specific element of the Collins amendment,
allowing the Fed to tailor capital rules to the insurance
business model. This issue is not whether applying bank
standards to insurers would require too much capital or too
little capital. There is general agreement that institutions
must have enough capital to pay for the cost of their failures.
Capital rules should, must accurately measure and address the
risks of the businesses to which they are being applied.
I look forward to Senator Collins' testimony and to our
panel. And, Senator Toomey, thank you.
STATEMENT OF SENATOR PATRICK J. TOOMEY
Senator Toomey. Thanks very much, Mr. Chairman, and thanks
for having this hearing. I think it is a very important topic.
I want to thank you and Senator Johanns for the legislation you
have introduced which addresses this and which I am a cosponsor
of.
I want to thank Senator Collins for joining us today and
for testifying before the Committee.
I just want to underscore a couple of points. I agree
completely that the insurance business model is completely
different in so many ways from a banking model that it would be
completely inappropriate to impose a bank-centric, a bank-
designed capital regime on insurance companies.
I would argue that the same principle applies with asset
management. That, too, is completely different and very
dissimilar from the banking business, and, therefore, a banking
capital regime does not make sense for asset managers either.
And I would also point out that, in addition to some danger
that the Fed may be inclined to go down this road of requiring
a banking type capital on insurance companies, I am concerned
that there is a danger that the Financial Stability Board might
also move in the direction of imposing European-style insurance
capital on an American industry that has evolved in a way that
is very different from the European model and for which that
model, I think--that capital model is not appropriate.
So I think this is extremely timely. You pointed out the
problems with AIG, and I know you know very well it was not
their insurance business that caused the problems at AIG. It
was activities that had nothing to do with insurance. And, in
fact, for many, many decades, the insurance industry has
weathered all kinds of storms and volatility and different
kinds of markets and circumstances and weathered it quite well,
which I think further suggests that this is an industry that
has an appropriate set of capital requirements.
So thanks for having the hearing. I look forward to the
testimony of our colleague.
Senator Brown. Thank you, Senator Toomey.
Senator Johanns.
STATEMENT OF SENATOR MIKE JOHANNS
Senator Johanns. What I was going to say has basically been
said, so I am not going to repeat that. We do know the
difference between the two industries, the banking and the
insurance. But I do want to make a very important point today.
First of all, I want to say thank you to the Chairman for
his efforts. My point there is that without your engagement, I
do not think we would be this far along.
The second point is to Senator Collins. Senator, without
you grabbing hold of this and trying to wrestle your way
through these technical, difficulty issues, I think we would be
stalled, to be very honest with you. I know you feel very
passionately about getting this right. That is what we want to
do. We want to make sure that whatever we end up doing with
capital standards we have got it right--we have got it right
for the banking industry, we have got it right for the
insurance industry.
And I think this is an opportunity with Dodd-Frank to
reflect upon what was there, is it working, what can we do to
improve it. And your engagement I think is critical to get us
to the finish line.
If we can have a breakthrough on this, then I think this is
literally a bill we can get passed, we can get done, get to the
President for his signature. So I just wanted to devote my
time, Senator, to just say thank you for being here today and
thank you for engaging on this very, very challenging,
difficult issue. But I think I see a light at the end of the
tunnel.
Thank you.
Senator Brown. Thank you, Senator Johanns.
Senator Tester.
Senator Tester. I am going to break Senate protocol here
because everything has been said, I just have not said it, and
I am not going to say it. So I look forward to Senator Collins'
testimony.
Senator Brown. Thank you, Jon.
Senator Collins, the senior Senator from Maine, welcome.
STATEMENT OF SUSAN M. COLLINS, A UNITED STATES SENATOR FROM THE
STATE OF MAINE
Senator Collins. Thank you very much, Mr. Chairman, Ranking
Member Toomey, Senator Johanns, Senator Tester. It is a great
pleasure to join you this morning. I wager that this hearing is
the most technical hearing that is being held on Capitol Hill
today, perhaps this week, perhaps this year.
I do thank you for convening this hearing on insurance
capital standards and for inviting me to come before you today
to share my views on this important topic. As a former
financial regulator myself, I appreciate how complex it is to
develop proper capital standards. For 5 years I headed Maine's
Department of Professional and Financial Regulation and oversaw
the Bureau of Banking, the Bureau of Insurance, the Bureau of
Consumer Credit Protection, and the Securities Division.
There are three issues that I would like to touch upon this
morning.
First, I would like to describe why I authored what has
become to be called ``the Collins capital standards
amendment,'' Section 171 of Dodd-Frank, and why I feel strongly
that it is so important that nothing be done to diminish or
weaken it.
Second, I want to emphasize my belief that the Federal
Reserve is able to take into account and should take into
account the differences between insurance and other financial
activities when consolidating holding company capital under
Section 171.
And, third, I will comment on how the Federal Reserve's
authority on this point can be clarified, if necessary, through
legislation that I have recently introduced, Senate bill 2102.
I am also very aware of the legislation that the Chairman, the
Ranking Member, and Senator Johanns--Senator Tester may be on
it also--have introduced, and I think we are not that far
apart. And I hope that we can continue to work to reach
consensus.
With regard to my first point, we all recall the
circumstances we faced 4 years ago as our Nation was emerging
from the most serious financial crisis since the Great
Depression. That crisis had many causes, but among the most
important was the fact that some of our Nation's largest
financial institutions were dangerously undercapitalized while
at the same time they held interconnected assets and
liabilities that could not be disentangled in the midst of a
crisis.
I remember the big debate during Dodd-Frank about what
financial institutions should be allowed to do. Should they be
involved in the derivative business? Should they be able to
issue credit default swaps? And I kept thinking, from the
perspective of the former regulator that I once was, that what
really was important was how much capital they had if they were
going to engage in riskier transactions. And when I looked at
the leverage ratios of, for example, Bear Stearns and found
that it was 30:1, I once again came to the conclusion that what
was important was having adequate capital standards.
The failure of these overleveraged financial institutions
threatened to bring the American economy to its knees. As a
consequence, the Federal Government was forced to step in to
prop up financial institutions that were considered too big to
fail. Little has angered the American public more than these
taxpayer-funded bailouts. That is the context in which I
offered my capital standards proposal as an amendment to the
Dodd-Frank bill.
Section 171 is aimed at addressing the too-big-to-fail
problem at the root of the 2008-09 crisis by requiring large
financial holding companies to maintain a level of capital at
least as high as that required for our Nation's community
banks, equalizing their minimum capital requirements, and
eliminating the incentives for banks to become too big to fail.
Incredibly, prior to the passage of the Collins amendment,
the capital and risk standards for our Nation's largest
financial institutions were more lax than those that applied to
smaller depository banks, even though the failure of larger
institutions was much more likely to trigger the kind of
cascade of economic harm that we experienced during the
financial meltdown. Section 171 gave the regulators the tools
and the direction to fix this problem.
Let me now turn to my second point, that Section 171 allows
Federal regulators to take into account the distinctions that
you have all discussed between banking and insurance and the
implications of these distinctions for capital adequacy. While
it is essential that insurers subject to the Federal Reserve
Board oversight be adequately capitalized on a consolidated
basis, it would be improper and not in keeping with Congress'
intent for Federal regulators to supplant the prudential State-
based insurance regulation with a bank-centric capital regime
for insurance activities.
Indeed, nothing in Section 171 alters State capital
requirements for insurance companies under State regulation nor
the State guarantee funds. Section 171 directs the Federal
Reserve to establish minimum consolidated capital standards
with reference to the FDIC's Prompt Corrective Action
regulations. But as I have publicly and repeatedly stressed,
Section 171 does not direct the regulators to apply bank-
centric capital standards to insurance entities which are
already regulated by the States. And having been in that role
of overseeing insurance regulation plus State banking
regulation, I am keenly aware of the difference and of the
regulation at the State level with the requirement for adequate
reserves and with the guarantee fund.
I have written to the financial regulators on more than one
occasion to make this point. For example, in a November 26,
2012, letter, which I would respectfully request be inserted in
the record, I stressed to financial regulators that while it is
essential that insurers subject to the Federal Reserve Board
oversight be adequately capitalized on a consolidated basis, it
was not Congress' intent to replace State-based insurance
regulation with a bank-centric capital regime. For that reason,
I called upon the Federal regulators to acknowledge the
distinctions between banking and insurance and to take these
distinctions into account in the final rules implementing
Section 171.
While the Federal Reserve has acknowledged the important
distinctions between insurance and banking, it has repeatedly
suggested that it lacks authority to take those distinctions
into account when implementing the consolidated capital
standards required by Section 171. As I have already said, as
the author of Section 171, I do not agree that the Fed lacks
this authority and find its disregard of my clear intent, as
the author of Section 171, to be frustrating, to say the least.
Since I am the author of the Collins amendment, since I am
Senator Collins, I think I know what I meant.
[Laughter.]
Senator Collins. Which brings me to my final point: how the
Federal Reserve's authority to recognize the distinctions
between insurance and banking may be clarified through
legislation that I have recently introduced, Senate bill 2102.
My legislation would add language to Section 171 to clarify
that in establishing minimum capital requirements for holding
companies on a consolidated basis, the Federal Reserve is not
required to include insurers so long as the insurers are
engaged in activities regulated as insurance at the State
level. My legislation also provides a mechanism for the Federal
Reserve, acting in consultation with the appropriate State
insurance authority, to provide similar treatment for foreign
insurance entities within a U.S. holding company where that
entity does not itself do business in the United States. That
was a very difficult issue to try to come up with a solution
to. I would encourage you to take a look at that section of the
bill that I have introduced. We have tried very hard to deal
with the situation where there is a foreign insurance entity
within a U.S. holding company when the entity does not do
business in the United States. I think we have come up with a
reasonable approach.
I should point out that my legislation does not in any way
modify or supersede any other provision of law upon which the
Federal Reserve may rely to set appropriate holding company
capital requirements.
In closing, I want to thank the Committee for holding this
hearing. This has been an enormously complex issue to resolve
in a way that does not undermine the intent of Section 171. I
want to especially thank you, Chairman Brown and Senator
Johanns, for your hard work. Your staff has worked night and
day with my staff over many months to try to craft language
that clarified the Fed's authority to provide the appropriate
treatment for insurer capital. I believe that the language that
I have introduced should give the Fed the clarity it needs to
address the legitimate concerns raised by insurers that they
not have a bank-centric capital regime for their insurance
activities imposed upon them.
This is an exceptionally complex area of the law, and I
recognize that some, including Members of this Committee, may
prefer a different approach than the one that I have taken. I
am also aware that there is an unusual accounting issue here
that involves some insurers, not all of them, not those that
are publicly traded, for example, but on whether there should
be generally accepted accounting principles or the SAP approach
that is used by insurers.
I am, of course, more than willing to continue to work with
you on a carefully tailored response to address those
legitimate concerns, but I would ask that we all be mindful of
the fact that we must not take action that would diminish the
taxpayer protections that provided the motivation for my
writing the Collins amendment and that are provided by the
critical reforms in Section 171.
Thank you very much for allowing me to testify. I realize I
went over my 5 minutes, but this is a very complex issue, and I
appreciate your indulgence.
Senator Brown. Thank you, Senator Collins, for your
explanation and your leadership and your hard work on this and
so much else in the Senate. Your letter, without objection, the
Collins letter, will be inserted in the record.
Senator Brown. Thanks for joining us.
Senator Collins. Thank you very much.
Senator Brown. We appreciate it.
Senator Collins said this is the most technical, maybe the
most technical hearing in the Senate, at least today if not for
the last few months, and that is why we have five really smart
people testifying--including Senator Collins, six really smart
people.
Senator Collins. I was just going to take a great exception
to that.
[Laughter.]
Senator Collins. Thank you, Mr. Chairman. And good save
there.
Senator Brown. If the witnesses would come forward, I will
begin the introductions.
[Pause.]
Senator Brown. Thank you to the five of you for joining us,
a couple of you on pretty short notice, so thank you for that.
Gina Wilson is Executive Vice President and Chief Financial
Officer of TIAA-CREF. Welcome, Ms. Wilson. Thank you for
joining us.
Daniel Schwarcz is Associate Professor of Law and Solly
Robins Distinguished Research Fellow at the University of
Minnesota Law School. His research primarily focuses on
consumer protection and regulation and property and casualty
and health insurance markets. Thank you for joining us.
Rodgin Cohen is Senior Chairman of the law firm Sullivan &
Cromwell. The New York Times described him as the ``Dean of
Wall Street Lawyers.'' Welcome, Mr. Cohen.
Aaron Klein is no stranger to this Committee room, having
served on the Banking Committee staff for some 8 years. He is
now Director of the Bipartisan Policy Center's Financial
Regulatory Reform Initiative. Welcome back, Mr. Klein.
And Michael Mahaffey is the Senior Vice President and Chief
Risk Officer for Nationwide Insurance in Columbus, Ohio.
Welcome to all of you. Ms. Wilson, would you like to start?
STATEMENT OF GINA WILSON, EXECUTIVE VICE PRESIDENT & CHIEF
FINANCIAL OFFICER, TIAA-CREF
Ms. Wilson. Thank you very much, Chairman Brown, Ranking
Member Toomey, Members of the Subcommittee. Thank you for
providing TIAA-CREF with the opportunity----
Senator Brown. Microphone? Either you are not speaking into
it or it is not on.
Ms. Wilson. Chairman Brown, thank you, also to Ranking
Member Toomey, Members of the Subcommittee, thank you for
providing TIAA-CREF the opportunity to testify on an important
issue to us and to the clients we serve.
My testimony today focuses on the final rules governing
capital standards and the Basel III accords issued by the
Federal Reserve Board in conjunction with the Office of the
Comptroller of Currency and the Federal Deposit Insurance
Corporation, which I will collectively refer to as the
``agencies.''
The final rules issued in July contain several changes from
the proposed rulemaking. Most notably for TIAA-CREF, it
temporarily exempted savings and loan holding companies, or
SLHCs, substantially engaged in insurance underwriting or
commercial activities.
We are a leading provider of retirement services in the
academic, research, medical, and cultural fields managing
retirement assets on behalf of 3.9 million clients with more
than 15,000 institutions nationwide.
While we are primarily engaged in the business of
insurance, we hold a small thrift institution within our
structure and as a result are registered as an SLHC. This
thrift provides us the opportunity to offer our clients deposit
and lending products integrated with our retirement, investment
management, and life insurance products and enhances our
ability to offer them the chance to attain lifelong financial
security.
Our status as an SLHC places us under the purview of the
Federal Reserve and consequently subjects us to the proposed
capital regime the agencies have set forth. TIAA-CREF supports
strong and appropriate capital standards that consistent with
SLHCs' operating models and the risks inherent in our
businesses. To be clear, this includes our support for
appropriate capital standards for banking organizations, and we
are not seeking to exempt insurers from the tenets of the Dodd-
Frank Act. We do not object to the Federal Reserve oversight to
enterprise capital standards. We are very concerned, however,
about how the final standards will be fully accounting for the
diverse business models under which different financial service
organizations operate. In short, we want to make sure that the
metrics we are measured on appropriately reflect the nature of
our business. Applying metrics designed for banks to an insurer
would be inappropriate and could have negative effects for the
economy, our customers, and insurers.
Bank-centric standards do not effectively recognize the
long dated nature of both sides of an insurer's balance sheet
and would likely encourage insurers to modify certain
investment practices and strategies that would be detrimental
to our core activities. A bank's core business is lending and
maturity transformation while insurers practice risk pooling
and management. As a result, insurers' investment portfolios
involve duration matching of assorted longer-term liabilities.
That is, we match our long-term liabilities with longer-term
investments. Imposing a capital framework designed to address
maturity mismatch inherent in banking on an insurer would
create a challenging insurer investment portfolio consideration
where none previously existed.
Under the rules, certain long dated investments, which are
typically less liquid than shorter-term investments, are
discouraged. Applying these bank capital standards on insurers
would also create a disincentive to invest in the very assets
that promote stability and solvency best.
The rules set forth by the agencies, if applied to
insurers, would have a detrimental effect on the ability to
offer affordable financial products, which in turn could
trickle down to individuals who utilize insurance products to
help them build a more secure financial future.
The rules also could have macroeconomic impact, for
example, creating disincentives for insurers to invest in asset
classes that promote the long-term economic growth such as
long-term corporate bonds, project finance, and infrastructure
investments, commercial real estate assets, private equity, and
other alternative asset classes.
In our comment letter to the Federal Reserve Board and in
our subsequent conversations with them, we have proposed
alternative methodologies for measuring an insurer's capital
that support both the policy concerns of the Federal Reserve
and ensure a strong capital regime, while also accounting for
the business of insurance. We hope that they continue to study
the issue and that they will find a sensible way to integrate a
capital standard that is appropriately designed for insurers.
In the meantime, we ask Congress to explicitly give the
agencies the ability to ensure that capital standards are
appropriately tailored for our business.
Thank you again for the opportunity to testify. We
appreciate the Subcommittee's interest in this issue and
affording us another venue in which to express our concerns.
I look forward to answering any questions you may have.
Senator Brown. Thank you, Ms. Wilson.
Professor Schwarcz, welcome.
STATEMENT OF DANIEL SCHWARCZ, ASSOCIATE PROFESSOR AND SOLLY
ROBINS DISTINGUISHED RESEARCH FELLOW, UNIVERSITY OF MINNESOTA
LAW SCHOOL
Mr. Schwarcz. Thank you very much, Chairman Brown, Ranking
Member Toomey, Members of the Subcommittee. My comments today
are going to be focused on what I am going to call ``insurance
SIFIs.'' These are nonbank financial holding companies that
FSOC designates as ``systemically significant'' and that are
predominantly engaged in insurance activities. Also, savings
and loan holding companies that have predominant insurance
businesses are covered by the Collins amendment. I deal with
that in my testimony, but I am not going to be talking about
that today.
In starting off talking about insurance SIFIs, I want to
note where I agree with members of this panel and with many of
you. I agree that bank-centric capital requirements should not
be applied to insurers. I agree that insurance and banking are
different and that, as a result of that difference, there must
be appropriately tailored capital requirements. I agree that
the Collins amendment gives the Fed the authority, very clearly
I think--I find the legal analysis of my fellow witness Mr.
Cohen to be very persuasive that the Fed has the authority to
implement that.
Here is where I disagree. There is a tendency in much of
the writing and much of the rhetoric to say the fact that we
should not apply bank-centric capital rules to insurers means
that we should completely defer to the State-based risk-based
capital requirements. That I do not believe is true.
I believe that Dodd-Frank requires the Fed to craft
appropriate capital requirements to apply to insurance SIFIs
and that those rules should differ from the State risk-based
capital rules.
Why is that? What we learned during the crisis is that
insurance can pose a real systemic risk. I deal with this in my
written testimony and much more thoroughly in an article that
is referenced in the written testimony.
People like to say, ``Oh, well, AIG, the portion of AIG
that got AIG into trouble was not about insurance.'' Well, that
is true with respect to its credit default swaps. But a major
problem at AIG was its securities lending business. Its
securities lending business involved the lending of insurers'
assets. So insurers' at AIG were intimately involved in the
problem.
Moreover, if you look at FSOC's report designating
Prudential as a SIFI, you will see that FSOC, after looking at
the portfolio of Prudential quite carefully, says that they
are, in fact, potentially susceptible to a run.
Now, I admit and I want to emphasize this risk is different
and less substantial than the risk of a run in banking. But at
the same time, it is real. There, in fact, have been runs on
insurance companies. Executive Life in 1991 was subject to a
run wherein policy holders removed from the company $3 billion
within the course of a single year.
Why is this significant? It can result in systemic risk not
because the insurer fails necessarily, but because an insurer
facing massive liquidity problems can immediately try to dump
its portfolio, thereby interfering with broader capital
markets. There is emerging research showing that insurers were
a big part of the problem in their purchase of mortgage-backed
securities leading up to the crisis and in triggering a fire
sale of mortgage-backed securities when they offloaded those
assets.
So the point I want to make is this: Insurance is less
systemically risky than banking, but it can be systemically
risky. Why then does that lead to the conclusion that we need
to have distinct capital requirements at the Federal level?
State risk-based capital requirements are not meant to deal
with systemic risk. They are meant to deal with consumer
protection. There is no, absolutely no consolidated capital
requirement of State-based regulation. Therefore, you do not
have any sense of whether the aggregated insurance business of
a company presents capital risk. You are not dealing with the
possibility of multiple gearing.
State risk-based capital requirements directly and
uncritically incorporate rating agencies in terms of assessing
capital penalties. A core provision of Dodd-Frank says that is
a mistake, that can cause systemic risk. And yet that is what
State regulation does, because it is not concerned about
systemic risk, it is concerned about consumer protection.
State risk-based capital requirements, remarkably, are
moving toward a system for reserving where life insurers'
reserves are going to be determined almost exclusively based on
insurers' private models--the very private internal risk models
that got companies in trouble in the years preceding the
crisis.
Here then is the point. I am not saying that State risk-
based capital requirements do not work. What I am saying is
that they are geared toward consumer protection concerns. Yet
we know that insurers, at least some insurers, raise systemic
risks. And as such, we need an appropriate risk-based capital
requirement at the Federal level for those conglomerates to
protect against that systemic risk.
Thank you very much.
Senator Brown. Thank you, Professor Schwarcz.
Mr. Cohen.
STATEMENT OF H. RODGIN COHEN, SENIOR CHAIRMAN, SULLIVAN &
CROMWELL LLP
Mr. Cohen. Chairman Brown, Ranking Member Toomey, and
distinguished Members of the Subcommittee, I am honored to
appear before you today to discuss the application of the
capital standards in Section 171 of the Dodd-Frank Act--the
Collins Amendment--to insurance companies that are savings and
loan holding companies or have been designated as
``systemically important'' by the FSOC. Let me begin by
commending your leadership on this important issue.
As far as I know, not a single legislator or regulator has
expressed the belief that, as a matter of policy, the same
capital framework should be automatically imposed on two very
different businesses--banks and insurers. Nor do I know of a
single Member of Congress who believes that Congress intended
such a result. This overwhelming agreement on what the right
answer is, both in terms of sound policy and effecting
congressional intent, led to Chairman Brown's suggestion that I
focus my remarks this morning on the legal analysis of whether
the Fed has the authority under Section 171 to reach this
answer.
In my view, the Federal Reserve does have the interpretive
authority to differentiate between banking organizations and
insurance companies solely on the basis of the language of
Section 171. This conclusion becomes compelling when one takes
into account the statutory framework of which Section 171 is a
part.
Section 171 does not require that designated insurers be
subject to the Bank Capital Framework, but only that the
capital standards for these entities not be less than bank
standards. Because Section 171 is not prescriptive as to how
this compatibility analysis should be conducted, Supreme Court
precedent makes clear that the Federal Reserve has the
authority to adopt an interpretation that implements Congress'
policy objectives.
Accordingly, even reading Section 171 in isolation, the
Federal Reserve has the necessary flexibility to apply capital
requirements to insurance companies that are appropriately
tailored for business, liability mix, and risk profile. But it
is also a fundamental canon of statutory interpretation and
construction that Section 171 must be read in its context. This
requires us to consider the other provisions of Title I of
Dodd-Frank, which collectively established the enhanced
prudential framework for the Federal regulation of both
systemically important banks and nonbank SIFIs.
Under the enhanced prudential standards of Section 165,
Congress required that there be both robust regulation and
differentiated regulation. These two objectives are not
inconsistent but mutually reinforcing, because regulation is
more effective when directed to the actual risk involved.
Section 165 is replete with congressional instructions that
the Federal Reserve apply enhanced prudential standards through
a differentiated approach. This includes a provision in Section
165 titled ``Tailored Application'' that expressly authorizes
the Federal Reserve differentiate among companies by category.
Another provision requires the Federal Reserve to take into
account differences between bank and nonbank SIFIs, including
the nature of a company's liability, in particular the reliance
on short-term funding.
In addition, in Section 169, Congress directed the Federal
Reserve to avoid duplicative requirements. Given that insurance
companies are already subject to a comprehensive risk-based
capital framework under State law, superimposing the Bank
Capital Framework would fail to fulfill that mandate.
Let me close with two points.
First, as I detail in my written testimony, there is an
interpretive solution that the Federal Reserve could apply
without legislation that conforms to the literal language of
the statute, the intent of Congress, and sound public policy.
Key to this solution would be the application of the risk-based
capital framework, as it may be modified, if necessary, to an
organization's insurance operations while applying bank capital
standards to the remainder.
Second, if the Federal Reserve is not prepared to act, I
would urge that Congress do so to prevent a result that is so
clearly unwarranted. I recognize the concern that some have
about opening up Dodd-Frank. But if there were ever to be a
revision, this is the time and place. An amendment to clarify
Section 171 could be both surgical and bipartisan; of most
importance, it is the right result.
I would be pleased to answer any questions you may have.
Thank you.
Senator Brown. Thank you, Mr. Cohen. I have never heard
``surgical'' and ``bipartisan'' in the same sentence.
[Laughter.]
Senator Brown. Mr. Klein, thank you.
STATEMENT OF AARON KLEIN, DIRECTOR, FINANCIAL REGULATORY REFORM
INITIATIVE, BIPARTISAN POLICY CENTER
Mr. Klein. Thank you very much, Chairman Brown, thank you,
Ranking Member Toomey, Members of the Subcommittees, and as you
mentioned, Chairman Brown, due to my service on the Committee
staff, allow me to extend a special warm thank you to the staff
of the Subcommittee and full Committee for all of their
excellent work.
Today I serve as the director of the Bipartisan Policy
Center's Financial Regulatory Reform Initiative, and I would
like to make four key points in my testimony this morning.
First, the business of insurance is fundamentally different
from that of banking and, hence, must be subject to appropriate
yet different capital standards.
Second, the Dodd-Frank Act envisions regulators overcoming
bank centricity and empowers them to do so.
Third, insurance company regulation is a real test case in
whether regulators can overcome their bank-centric approach.
And, finally, fourth, going forward, a better regulatory
structure would include a Federal insurance regulator and an
optional Federal charter.
To understand why it is so important that banks and
insurance companies be subject to different capital regimes,
one must first appreciate the differences in their business
models.
At its core the business of insurance is about aggregating
risks, matching a company's liabilities to its assets.
Aggregating risk, paradoxically, makes insurers less risky by
avoid adverse selection and protecting themselves against
statistically unlikely outcomes.
By contrast, banks are in the business of mitigating risk.
For example, banks transfer timing risk by allowing depositors
to instantly access their money while making longer-term loans
to consumers and businesses. In contrast to insurance
companies, banks avoid overconcentration of a specific risk. In
fact, overconcentration is a classic red flag for safety and
soundness concerns for bank regulators.
Mixing insurance and banking has generally not worked for
financial services firms. It remains to be seen whether a
regulator can effectively regulate both businesses.
Under Dodd-Frank the Federal Reserve is now the regulator
for a diverse set of insurance companies. It is unclear how
broadly appreciated that fact was during consideration of Dodd-
Frank. What is clear is that Dodd-Frank's decision to move
thrift holding companies along with regulatory responsibility
for nonbank SIFIs to the Federal Reserve was given along with
the ability and responsibility for the Fed to develop
appropriate capital standards, tailored to each entity or
separate class of institutions it regulates. This requirement
to tailor capital standards is a key theme throughout Dodd-
Frank.
Even if the Federal Reserve is unwilling or unable to use a
tailored approach, the FSOC could solve this problem. Among the
responsibilities granted to FSOC are to make recommendations to
the Federal Reserve concerning the establishment of heightened
prudential standards, including capital standards, for nonbank
companies supervised by the Board.
My first preference would be for regulators to follow the
intent of Congress and tailor capital standards for insurance
companies. My second preference would be for FSOC to use this
authority, make recommendations which the Board could then
adopt. If neither approach is implemented, I would then support
a legislative solution such as the bipartisan one proposed by
Chairman Brown and Senator Johanns or possibly the one
described this morning by Senator Collins.
This hearing raises the fundamental question of who is best
positioned to find the right capital regulatory structure for
insurance companies. BPC's Regulatory Architecture Task Force
has been examining the entire financial regulatory structure in
a post Dodd-Frank world. The task force's full report will be
released this spring and will contain many recommendations for
how we can improve our current regulatory structure. One
recommendation will be to create a Federal insurance regulator
and an optional Federal charter. This is particularly important
given the ramifications of making a mistake by applying the
wrong capital standards to a select set of insurers. As Roy
Woodall, the independent FSOC member appointed specifically for
his expertise in insurance, stated in his dissent on whether to
designate an insurance company as a SIFI, FSOC's analysis was,
and I quote, ``antithetical to a fundamental and seasoned
understanding of the business of insurance, the insurance
regulatory environment, and the State insurance resolution and
guaranty fund systems.''
In conclusion, BPC's Financial Regulatory Reform Initiative
has found that Dodd-Frank generally empowered financial
regulators with substantial authority and flexibility to use
their tools to improve regulation and achieve better regulatory
outcomes. Treatment of insurance companies is an early and
critical test case of financial regulators' ability to adhere
in practice to the construct created in Dodd-Frank: that
financial regulators can overcome bank centricity in handling
their new-found responsibilities for nonbank financial
companies. I hope that they are up to the test. The stakes are
simply too high.
Thank you very much. I look forward to responding to your
questions.
Senator Brown. Mr. Klein, thank you.
Mr. Mahaffey, welcome. Thank you.
STATEMENT OF MICHAEL W. MAHAFFEY, CHIEF RISK OFFICER,
NATIONWIDE MUTUAL INSURANCE COMPANY
Mr. Mahaffey. Chairman Brown, Ranking Member Toomey, and
distinguished Members of the Subcommittee, thank you for the
opportunity to appear before you and testify today.
My name is Michael Mahaffey, and I am the Chief Risk
Officer for Nationwide Mutual Insurance Company. I am
testifying on behalf of Nationwide but will also represent the
perspective of a diverse group of insurers that fall under
Federal Reserve supervision.
As Nationwide's Chief Risk Officer, I am responsible for
overseeing the company's approach to managing its risk profile.
A critical part of my role is to ensure that Nationwide meets
its internal and external capital requirements so the company
is always well positioned to honor its promises to our policy
holders. As such, I believe I can offer a helpful perspective
on appropriate capital regimes for insurers.
Nationwide is a Fortune 100 mutual insurance company based
in Columbus, Ohio. Roughly half of Nationwide's revenue is
derived from our property and casualty businesses, and half is
derived from our life insurance and related businesses.
Nationwide also provides banking products and services through
Nationwide Bank, a Federal savings bank insured by the FDIC.
While Nationwide bank is critical to our customers and business
strategy, it represents less than 3 percent the total assets of
the combined organization.
Nationwide is subject to the Collins amendment by virtue of
being a savings and loan holding company, or SLHC. Nationwide
Bank is also independently subject to the minimum capital
standards in the Collins amendment. We support the application
of the Basel banking capital standards to Nationwide Bank.
Furthermore, we are not seeking to lower capital standards for
Nationwide Mutual, and we do not oppose utilization of a group-
wide capital framework. Capital strength is core to our
business proposition, providing our policy holders financial
protection when they need it most. We only seek to ensure that
any capital standards established by the Federal Reserve are
tailored to the business of insurance; we believe this is
consistent with congressional intent.
The Federal Reserve has maintained an interpretation of the
Collins amendment that constrains their ability to tailor these
capital rules. We respectfully disagree with this
interpretation, and we support Congress passing legislation to
clarify that the Federal Reserve can and should establish a
separate tailored capital framework for insurers that
appropriately reflects the industry's unique business model,
risk profile, and asset-liability management practices.
Specifically, we support S. 1369, legislation that would
clarify that the Federal Reserve can appropriately tailor those
capital rules for insurers, but continue to apply banking
capital standards to depository institutions owned by insurers.
I would now like to turn to the problems with imposing a
bank-centric capital regime on insurers. The Basel III capital
regime was designed specifically for banks. This framework is
focused on the asset side of a company's balance sheet,
including the predominant banking risks of credit, market,
counterparty, and liquidity risks.
Given this risk profile, systemic economic events can
subject banks to destabilizing runs and force them to quickly
sell assets at a loss to meet their demand deposit obligations
and funding needs.
Conversely, the primary risks facing insurers, found on the
liability side of the balance sheet, are generally not as
sensitive to the same systemic economic risks. These liability
risks include, for example, weather, mortality, morbidity, and
longevity risks, which are not as highly correlated with
macroeconomic cycles.
One example of the problem this framework poses for
insurers is the 100-percent risk weight imposed on corporate
bonds, an approach which fails to distinguish bonds based on
the credit quality of the borrower. This charge overstates the
risk associated with high-quality assets, particularly when
compared to riskier commercial and industrial loans, which
receive the same 100-percent risk weight. As of year-end 2012,
corporate bonds comprised about 48 percent of insurer general
account assets as compared to around 6 percent for banks. Thus,
overstating the risk on such a substantial portion of an
insurer's investment portfolio will likely have a significant
impact.
Insurers subject to this regime could decide to take on
additional credit risk by shifting their investment portfolios
to higher yielding, lower-quality corporate bonds that receive
the same 100-percent risk weight. This additional risk taking
would appropriately require increased capital under the State
RBC framework, but would be ignored under Basel III as
proposed.
In addition, to the issue of corporate credit risk, the
Basel framework's treatment of insurers' separate account
assets is problematic. These separate account assets would
potentially receive capital charges for risks not borne by the
insurer, resulting in a substantial and unreasonable capital
cost.
In summary, the risk weights applied to insurers in the
Basel regime would overcharge for some risks, entirely ignore
others, and thereby potentially incent poor risk-taking
behavior, contribute to a contraction in credit, and/or
negatively affect availability and affordability of important
insurance products.
In conclusion, I would like to reiterate a few important
points.
First, we are not objecting to group supervision by the
Federal Reserve.
Second, we are not objecting to the concept of a
comprehensive group capital requirement for SLHCs or SIFIs.
Third, we are not objecting to utilization of a Basel
framework for our bank.
And, finally, we are not seeking lower capital standards.
Indeed, we support strong capitalization as part of our core
business proposition. We are simply advocating that there is no
one-size-fits-all model for assessing risk and by extension no
universally applicable framework for determining capital
requirements. We believe strongly that the Federal Reserve
should have the latitude to utilize any tool, or combination of
tools, necessary to effectively assess the risk profile and
capital requirements of a holding company, taking into account
material differences in their business models.
We appreciate the leadership of Senators Brown, Johanns,
and Collins on this important issue, and thank the Subcommittee
for the opportunity to comment.
Senator Brown. Thank you, Mr. Mahaffey, and thank you all
for staying very close to the 5 minutes.
I am going to ask a series of questions which I would ask
of each of you. I would like to ask for brief answers, if
possible yes or no. At 11:30 there will be a series of votes on
the floor, so I want everybody on the panel to get a chance to
ask questions. So just go work from left to right. Ms. Wilson,
do you agree that the insurance business has a different model
from banking and presents different risks? Just yes or no from
each on the panel.
Ms. Wilson. Yes.
Mr. Schwarcz. Yes.
Mr. Cohen. Yes.
Mr. Klein. Yes.
Mr. Mahaffey. Yes.
Senator Brown. OK. Do you think, as suggested by Ms.
Wilson, that applying Basel III to insurers would or could have
a negative impact on the safety and soundness of these
institutions? Probably not yes or no there, but brief answers,
if you could. Ms. Wilson?
Ms. Wilson. Yes, I think it could, at least in part because
it could sway the way that insurers make investment decisions
for its investment portfolio.
Senator Brown. Professor Schwarcz?
Mr. Schwarcz. Yes, I agree that applying mechanistically
bank capital rules to insurers would not be appropriate.
Mr. Cohen. Yes, I would agree. Basel III is not directed to
insurers but to banks.
Mr. Klein. Yes.
Mr. Mahaffey. Yes, I would agree. Anytime you have a system
that under- or over-charges for risks and does not account for
the nuances of a business model, you run that risk.
Senator Brown. Thank you. Third question. Do each of you
agree that we could address this by regulation without actually
going the legislative route? Ms. Wilson?
Ms. Wilson. My lawyers have assured me that their
interpretation of the Collins amendment suggests the Federal
Reserve does have the authority to make accommodations for the
other businesses that are incorporated in an insurance holding
company.
Senator Brown. Mr. Schwarcz?
Mr. Schwarcz. I would frankly just refer you to Mr. Cohen's
legal analysis, which I think is superb and I, you know,
independently agree with. I think that the language is pretty
clear in context that regulation can solve the problem.
Senator Brown. Mr. Cohen, would you like to respond to Mr.
Schwarcz's assessment of your brilliant legal mind?
[Laughter.]
Mr. Cohen. Solely to thank Professor Schwarcz for his
accolade.
Senator Brown. Mr. Klein?
Mr. Klein. Yes, I think the Federal Reserve can fix the
problem. I also point out that I think that FSOC could direct
the Fed to fix the problem as well.
Senator Brown. OK.
Mr. Mahaffey. And I would say yes, small asterisk, that I
think ultimately if the interpretation remains different by the
Fed, then I think that there has to be the possibility of
another legislative action.
Senator Brown. Thank you. And understanding that the
solution that we ask for, whether it is legislative or the Fed,
to tailor capital rules for SIFI insurers, would the Fed still
have ample tools to regulate these institutions in other ways?
Ms. Wilson. The Fed absolutely has authority to supervise
the entirety of the consolidated group, and so we think that
they would be well positioned to carry out their
responsibilities.
Mr. Schwarcz. I am not sure I totally understand the
question.
Senator Brown. If we move forward on legislation or the Fed
makes this--follows the suggestions of this panel, would they
still have the ample tools to regulate institutions in other
ways?
Mr. Schwarcz. Well, I guess I would answer as follows: I
think that one important element of what the Fed should do and
needs to do under Dodd-Frank is to craft their own capital
rules for insurance SIFIs. Those rules should not just be bank
rules, but nor should they just be as, frankly, some of the
legislation. And here is where I will disagree with Mr. Cohen.
Some of his suggestions suggest that we should not just
completely defer to State risk-based capital rules with respect
to insurers. And here I would say that is actually quite
important that, for entities that have been labeled as
``systemically risky,'' we have capital requirements that are
on a consolidated basis, including insurers, that take into
account the specific systemic risks that are identified by FSOC
that insurers pose.
So while I would agree that we need different capital
rules, I would--I think actually it would hinder the Fed's
ability to regulate insurance SIFIs if we mandated, as some of
this legislation does, I believe, that they completely defer to
the State risk-based capital rules with respect to the
insurance entities.
Senator Brown. Mr. Cohen?
Mr. Cohen. I actually would not disagree with Professor
Schwarcz, because I do believe that the Federal Reserve has
substantial authority, both under Section 165 and for the S&L
holding companies under the Bank Holding Company Act, to
incorporate whatever additional requirements it would deem
appropriate for an insurer.
Senator Brown. Mr. Klein?
Mr. Klein. Yes, the Fed does have the authority. Whether
they have the expertise, capability, and understanding of the
differences of insurance companies through the regional bank
system and the Reserve Board is an open question.
Senator Brown. Mr. Mahaffey?
Mr. Mahaffey. As to the question of whether they have the
appropriate tools, I actually think that S. 1369 actually
broadens the possible set of tools that they could use at their
disposal. I think it is their current interpretation of Collins
that, in effect, limits the toolkit that they are asserting
they can use for this. So I would actually suggest that this in
no way shape or form--at least 1369 would not limit them from
continuing to, if they chose to do so, and I think all
panelists would agree that would be a bad idea.
If they chose to continue to use Basel III as a
consolidated framework, even under that bill they could choose
to still do so. They are simply not required to as they
interpret Collins to instruct them today.
Senator Brown. One last question. I am sorry to go over my
time a bit. For Mr. Cohen specifically, the Fed has taken
regulatory steps, as you know, to address unintended
consequences presented by the text of Dodd-Frank. For example,
the text of the Volcker rule exempts insurance from the
proprietary trading prohibition but does not exempt their
general account investments from the covered funds prohibition.
Regulators, including the Fed, have extended this exemption.
Section 716, the swaps pushout provision, applies to
insured depository institutions, but the Fed extended its
transition period in temporary relief to uninsured branches and
branches of foreign banks based upon, among other things,
legislative history.
My question is: Do you believe the Fed has the flexibility
under Collins to deal with any issues that arise? And how do
these past actions compare to the issue that we are dealing
with here? Do they strengthen the case for the Fed to act?
Mr. Cohen. I think those are, in fact, perfect analogies,
Senator. They show that the Fed has the capacity to act in
statutory schemes, which are very complex and very technical,
as Senator Collins testified, to deal with getting to the right
solution, even if there is ambiguity in the statute. And,
frankly, with respect to 171, I do not think there is that much
ambiguity as to the Fed's ability to act.
Senator Brown. Thank you.
Senator Toomey.
Senator Toomey. Thank you, Mr. Chairman.
Well, I think that our witnesses today made a pretty
bulletproof case that the nature of the insurance industry is
sufficiently different from the nature of banking to merit a
different capital regime. I completely agree.
Mr. Cohen, I know this is not central to the discussion of
the hearing, and it is not included in your testimony, but I
wonder if you would comment on this, which is it strikes me
that the asset management business is also fundamentally
different from banking in a variety of very important ways. And
given that it, too, is different from banking, do you see
problems in trying to apply bank-centric regulations to the
asset management business as well?
Mr. Cohen. I would, Senator Toomey, and I think your
analysis is correct. And, moreover, Congress explicitly
notified the Federal Reserve and FSOC that asset managers were
to be treated differently. There are two specific references in
Section 165 itself to asset managers in the context of
differentiation.
Senator Toomey. Thank you.
Does anybody disagree with Mr. Cohen's assessment there?
[No response.]
Senator Toomey. Great. Thank you.
A second question also for Mr. Cohen, and I think this
would--I will ask anyone else to comment as well. But if an
insurer is not designated as a SIFI, does everybody agree that
it is the intent of Dodd-Frank that the insurer would then,
therefore, be subject only to the various States--the State
capital regimes? Mr. Cohen first.
Mr. Cohen. Yes, Senator, assuming that it is not a savings
and loan holding company, you are exactly right. It would be
just the State insurance regulations.
Senator Toomey. OK. Thank you.
Yes, go ahead.
Mr. Schwarcz. You just asked if anyone disagreed.
Senator Toomey. Sure.
Mr. Schwarcz. I just want to clarify. I think that it is a
more--there is a difficult issue with respect to savings and
loan holding companies and bank holding companies that are
predominantly engaged in insurance and regulated by the Fed.
And I do not think it is actually clear that Dodd-Frank would
say, well, there is no role for the Fed to play there on a
consolidated basis, because those entities are both insurance
companies, but they are also bank holding companies or savings
and loan holding companies. They are both.
And so I think that it is actually relatively clear from
the text of Dodd-Frank that we need a capital regime that is
appropriate to their insurance side of their business, but we
also need a capital regime that is appropriate to the fact that
they are a bank holding company or savings and loan holding
company. And I guess that gives the analogy, if I am a lawyer,
I am not an insurance agent; but if I wanted to become an
insurance agent, I would need to be licensed as a lawyer and
licensed as an insurance agent.
And so sort of the same thing. If you are doing two things,
you need to comply with the appropriate regulatory rules with
respect to both of those regimes.
Senator Toomey. OK. But you are focusing on exclusively
those that have another charter, another--you know, in this
case a savings and loan?
Mr. Schwarcz. Correct.
Senator Toomey. OK. Mr. Klein, a quick question for you,
and this goes to the point I made in my opening comments. One
of the things I have a concern about is the Financial Stability
Board importing what is essentially a European or international
capital approach to the American insurance industry, and I am
concerned about this in part because it seems to me that the
European insurance model is typically quite different from the
American model in many ways, and so a capital regime that may
be suitable over there may not be suitable here. And, in
addition, the Europeans might very well view the role of
capital differently than we have historically viewed it here.
Do you share this concern as well?
Mr. Klein. I do, Senator. In my written testimony, I make
reference to the fact that one of the things Dodd-Frank did is
try to create a unified international voice for insurance,
which we were lacking, frankly, going into the crisis in a pre-
Dodd-Frank world. And it created the Federal Insurance Office,
or FIO, and actually specifically empowered FIO with that
objective and a seat on the proper international board.
Subsequently, the Federal Reserve has now, to my
understanding, applied for a similar seat on that board, which
makes some amount of sense given the fact that the Fed has
these responsibilities. On the other hand, it needs to be
clarified--and I urge in my written testimony that the
regulators do so--that FIO is the international voice for the
United States on insurance matters, as made clear in Dodd-
Frank.
Senator Toomey. Thank you very much.
Thanks, Mr. Chairman.
Senator Brown. Thank you, Senator Toomey.
Senator Reed.
Senator Reed. Well, thank you very much, Mr. Chairman, and
thank you, panel, for excellent presentations.
Mr. Cohen, are you aware of any published memoranda by the
Federal Reserve basically defending their position?
Mr. Cohen. No, Senator, I am not. This all seems to be in
testimony by Governors.
Senator Reed. So it is sort of colloquial, ``We do not
think we have it,'' but there is no official documentation you
have seen?
Mr. Cohen. Not that I am aware of, Senator.
Senator Reed. OK. One aspect, I think, that we have dwelled
on is the difference and the distinct difference between the
balance sheets and the operations of an insurance company and a
bank holding company. But there are activities that could be in
common, particularly on a consolidated basis, and I think
Professor Schwarcz suggested this, that on a consolidated basis
there is probably the issue of systemic risk; and, second, the
obligation of the Fed to sort of control that risk. And your
suggestion is it not be done through Basel III, which I think
makes a great deal of sense, but it has to be done. Is that a
fair approximation?
Mr. Schwarcz. That is exactly right, Senator. The point is
that we now know that nonbank holding companies that are
predominantly engaged in insurance can be systemically risky.
We need to apply group capital requirements to them, and
crucially, we cannot just carve out the insurers and say that
our group capital requirements only apply to the part of the
business that is not regulated by States. Because if you look
at AIG, one of the big problems there was with the interactions
among the different components of the company. The insurance
companies were really used by other portions of the company for
the securities lending problems. And there are also just many
other systemic risks associated with insurance particularly.
Now, again, those are lesser than banks. We need to have a
tailored regime for those. But where my concern is is that
there is slippage. When we all agree--and we all agree in this
room, I think--that we should not have bank capital
requirements applied to insurers, there is slippage then to the
conclusion that that means that the Federal Reserve should not
apply its consolidated capital requirements to the portions of
the insurance SIFI that are insurance companies.
Senator Reed. Well, let me ask you all to comment on sort
of a procedural approach, which seems to make sense to me, that
if this was to be done, then it typically would be done through
a proposal of a rule by the Federal Reserve allowing the
industry to comment in detail about the specific application
and also any general points they want to make. And that the
rule would then be adopted going forward.
Is that a sensible approach that could be undertaken right
now by the Federal Reserve? We will start with Ms. Wilson.
Ms. Wilson. It certainly could be, and I think many of the
companies that are represented on this panel and in previous
hearings have actually spent quite a bit of time with the
agencies to try to help advance discussion about how
regulations could be proposed.
Senator Reed. Thank you.
Professor?
Mr. Schwarcz. Yes, absolutely, I think that the Fed can and
should under its existing authority do what many of us are
suggesting.
Senator Reed. Mr. Cohen?
Mr. Cohen. Yes, Senator, I think they could do it, and it
makes good sense to do it.
Senator Reed. Thank you.
Mr. Klein. Yes, Senator, that is a wise and prudent course.
Senator Reed. OK.
Mr. Mahaffey. I would concur.
Senator Reed. Thank you very much. I know when to stop.
Thank you very much.
[Laughter.]
Senator Brown. Senator Johanns.
Senator Johanns. Thank you all for being here.
Just listening to your testimony, one of the things that
occurs to me is how much agreement there is, and, you know,
there are different viewpoints on this panel on probably many
things, but it does strike me how much agreement there is.
One thing, though, I would like to explore a little further
is this whole issue of how much authority the Fed has, because
here is the problem I have as a lawmaker. In every possible way
you can think of, we have asked the Fed if they have this
authority. When Chairman Yellen was going through the
confirmation process, tons of questions were sent her way, you
know: Do you have the authority? Very consistently, the Fed has
passed. They have said, ``No, we do not.''
And so we are kind of in this situation where we know the
easy pathway would be for the Fed just to issue regulations
that recognize the difference between insurance and banking.
But it does not look like that is going to happen.
Under those circumstances would you agree with me--and I
will just go down the line here--that legislative language is
necessary then to give the Fed clear direction on this issue?
Ms. Wilson. I think the legislative approach would
definitely make it clear that the authority exists in the
Federal Reserve to do what is needed.
Senator Johanns. Professor?
Mr. Schwarcz. An appropriate legislative course would be
wise, if that came to fruition.
Mr. Cohen. Senator, although one would hope that the Fed
may be willing to reconsider after the unanimity expressed
today to which you referred is so clear, in the absence of
prompt action by the Federal Reserve, I fully agree that
legislation is the only recourse.
Mr. Klein. Senator, as I mentioned before, I think in
addition to the Fed having the opportunity to do the right
thing, there is a role that FSOC could play in helping direct
the Fed to do the right thing. Absent those two positions, then
I would agree that legislation becomes necessary to avoid a
problematic policy outcome, and that to some degree would be a
little bit disappointing as this is one of the first areas
where regulators are attempting to overcome their bank-centric
nature in history to extend the provision of Dodd-Frank into a
nonbank world.
Mr. Mahaffey. And I would agree. I think this has been the
classic stumbling block, as we have all approached the Fed. I
think if this issue does not get resolved, it is one thing for
all of us to be unified in our opinion that the Fed has this
discretion and current authority. But if this is not resolved,
I think the only prudent path is to actually make clear through
a legislative solution that they do have this authority. And,
again, I think that actually broadens the toolkit they have at
their discretion, and it does not remove anything that they
have at their discretion today in the Collins amendment. So I
think that might be the path that needs to take place.
Senator Johanns. Let me stay with you a second. One of the
things that has occurred to me about the potential that bank-
centric rules would be applied to insurance companies is that
you could actually increase the risk that insurance companies
are exposing their customers to, if you will. Do you agree with
that analysis on my part?
Mr. Mahaffey. I think generally, yes. Anytime you apply a
model that attempts to assess risk, and if that model ignores
risks, underprices risks, or overprices risks relative to the
model of the company you are trying to measure, then you can
unintentionally create incentives for them to move the risk
portfolio to comport with that model. So whenever you try and
impose a capital charge that does not actually get to the
economics underlying the business model, whether that is on the
assets or liabilities, the answer is yes, you can actually have
perverse incentives for them to take more risk rather than less
risk.
Senator Johanns. Exactly. Let me just move down the line. I
would like comments by others, just very brief comments about
that.
Mr. Klein. Absolutely, Senator. The hallmark of every
financial crisis is the mispricing of risk at its core, mixed
with leverage. And it would seem to me that if one of the
defenses against a financial crisis is appropriate risk-based
capital, then applying inappropriate risk-based capital would
exacerbate the possibility of a financial crisis.
Senator Johanns. Mr. Cohen?
Mr. Cohen. Senator, when you overprice risk, there is then
a threat to the consumer as well, because that threatens to
drive the insurer or any financial institution out of the
product or service for which risk has been overpriced.
Senator Johanns. Professor?
Mr. Schwarcz. Let me just make one point. We are talking
about two different sets of entities: insurance SIFIs and then
savings and loan holding companies and bank holding companies
that engage in insurance.
I actually think we need to disaggregate the analysis. I
agree completely with respect to insurance SIFIs. With respect
to savings and loan holding companies and bank holding
companies that have insurance, they are bank holding companies,
they are thrift holding companies. And so the question of
whether or not they should get a special exemption from the
rules that normally there is actually, I think, much more
difficult.
So I think that it is true that you need absolutely an
appropriate capital regime for the business you are dealing
with, but recognize that bank holding companies and thrift
holding companies that predominantly engage in insurance are
bank holding companies and thrift holding companies, and we
should regulate them as such.
Senator Johanns. If you can be very quick, because I am out
of time, Ms. Wilson. I would like to hear your reaction to
that.
Ms. Wilson. I would like to just echo Mr. Cohen's comment.
The mis-assignment of risk to capital and requiring insurers to
carry more capital than would otherwise be necessary is
actually a disadvantage for our policy holders. They would get
less attractive returns on their retirement funds with us if we
were forced to go to a different part of the investment
universe to deploy our resources.
Senator Johanns. Thank you.
Thank you, Mr. Chairman.
Senator Brown. Thank you, Senator Johanns.
Senator Tester.
Senator Tester. Thank you, Mr. Chairman.
This is a question for Ms. Wilson and Mr. Mahaffey.
Assuming that Basel capital standards would be applied to your
businesses--and I do not think anybody thinks that should be
the case, but assuming they would be, could you tell us about
the impact that would have on your ability to manage your
assets and liabilities? You can go first, Ms. Wilson.
Ms. Wilson. Thank you for the question. We have a fairly
sophisticated investment allocation algorithm, and if the risk
capital charges are different than they currently are, we could
potentially change the portfolio mix that we use to deliver on
decade-long commitments to our policy holders. And that, as I
think I just said to Senator Johanns, might reduce the amount
of investment income that they would have to provide for their
retirement security.
Mr. Mahaffey. Yes, and I would echo those comments. I would
also add that it would force you to look at the total capital
position. Nationwide holds substantially more capital than
would be imposed upon us by Basel III, so, again, this is not
about aggregate capital. But as you subdivide the organization
and you get down to certain products, you would now be forced
to sort of triangulate between an internal economic view of the
risk we are taking when we write a product, the current State-
based regulatory requirements for the risk we are taking in a
product, rating agency views, and now you would layer in
another view, all of those views likely resulting in very
different answers as to how much capital.
And so back to the point of if you have the wrong model
that does not take into account the real risks of the products
and the assets that you are putting behind those products, then
we would be forced to probably make modifications either to the
price of the products or the lines of business that we choose
to be in.
Senator Tester. OK. Impact on the economy, you talked about
the impact on potential retired folks. Any other impacts that
come to mind? Go ahead.
Ms. Wilson. If I might, one of the important sources of
strength for the economy during the economic downturn were
large insurance companies that actually invested in
infrastructure, long dated assets, because we did, in fact,
have the capital strength to make long-term investments. Even
when the market was sort of on its heels, we had net inflows in
many cases. And so we were seen as a source of strength to the
economy. We make very long term investments in things like
bridges and highways and support municipal projects that need
funding across the United States right now. And so it is not
just the investment returns for our participants, it is also
the macroeconomic impact that many of our investment portfolios
support.
Senator Tester. OK. This is a question for any witness or
all witnesses that want to respond to it. It goes back to
Senator Toomey's question on international efforts. Share your
concerns about potential inconsistencies in coordination
between international regulations and domestic, if you might.
Mr. Cohen. I would be glad to start, Senator.
Senator Tester. Sure.
Mr. Cohen. I think that this is one of the most significant
issues confronting the financial system, because we are a
global system today, and the more we can do to have concerted
action and collaborative action, the better off I think the
financial institutions in the United States will be and the
financial institutions outside the United States will be. There
is a lot left to be done.
Senator Tester. Anybody else want to respond?
[No response.]
Senator Tester. Mr. Cohen, I will stay with you then. What
can the Federal regulators do to ensure that the international
negotiations do not disadvantage American insurers?
Mr. Cohen. I think it is extremely important that they not
sacrifice what is the right solution for consensus. Sometimes
there is a feeling that in the rush to get to consensus, the
desire--which is certainly a key objective--that the best
interests of the U.S. financial institutions are sacrificed,
not in the sense of competitive best interests but just in what
makes sense.
Senator Tester. Go ahead, Mr. Klein.
Mr. Klein. I would add that it is very important when you
are engaged in an international negotiation that you are able
to speak with one unified voice, and Dodd-Frank clearly gave
that voice to the Director of FIO in the Treasury Department,
and that he should continue to serve that role, and the Fed and
NAIC should make clear that that is his role in an
international context.
Senator Tester. OK. Anybody else?
[No response.]
Senator Tester. One last question. This goes back to Ms.
Wilson and Mr. Mahaffey. Nationwide has a bank, TIAA-CREF has a
thrift. Can you describe what services your bank and thrift
provide and why it is important to your ability to serve your
policy holders and why you would not want to eliminate these
offerings? You can go ahead and go first, Ms. Wilson.
Ms. Wilson. We have, as I mentioned in my opening
statement, 3.9 million clients whose retirement funds are
deposited with us. We believe that we can be much more helpful
to them in building a life of financial stability if we can
offer additional services like life insurance, savings
accounts, mortgage loans, potentially car loans, things that
are really retail nature but really speak to the needs of the
average employee on our institutional clients' sort of
workforces.
Senator Tester. Good. Mr. Mahaffey, would you like to add
to that?
Mr. Mahaffey. Sure, I will echo those comments, but I will
also just give another example on the property/casualty side.
So our bank, while it is small, it is critically important to
our other policy holders. An example would be in the wake of a
disaster we have the ability to issue rather than a bank draft,
because of our bank we can issue a Nationwide bank debit card
that gives our customers immediate relief and access to use
those funds anywhere a credit card would be served. So we try
and integrate it with our product portfolio. Our desire is not
to build a big stand-alone bank but to use it as a way to serve
our existing policy holders better.
Senator Tester. I appreciate that, and I also appreciate
all the testimony by all the folks on the panel today. This
probably is not televised, Mr. Chairman, but it would have been
nice if they could have seen----
Senator Brown. It is in Billings.
Senator Tester. It is in Billings?
[Laughter.]
Senator Tester. Thank you.
Senator Brown. I made special arrangements because I knew
you were going to be here.
Senator Tester. Thank you very much. But it would have been
nice to have the Fed, and hopefully they will take a look at
the testimony that you guys put forth, because I think it was
very good. Thank you.
Senator Brown. Thank you, Senator Tester.
There is a series of votes to be called around 11:30, so I
will ask another couple of questions, and perhaps Senator
Johanns if he wants, and we will see.
A follow-up, Mr. Mahaffey, on Senator Tester's question.
Either Ms. Howe or somebody from Nationwide told us about what
happened in Joplin, Missouri. If you could sort of illustrate
more graphically your answer to Senator Tester's question about
what that only $6 billion out of $180 billion--you are a $180
billion institution, $6 billion in your bank, how that plays
out for your policy holders?
Mr. Mahaffey. Sure. And as you mentioned, we were an
insurer that was able to help in the wake of the Joplin
disaster. We happened to have a number of insureds that were
there, and that was a good example of the use of this claims
card, we call it, which allows our claims agents to be able to
issue these pre-loaded debit cards on the spot for someone who
suffered a loss in the wake of a disaster like Joplin. And that
can be very helpful, rather than attempting to get a bank draft
when your bank may not actually still be standing.
We have had a phenomenal response and feedback on that
program, so it is just another example of a way in which we can
provide a very value-added service, be there for our members
when they need us most, and we view that as our model for the
bank being integrated with the rest of our insurance
organizations, not necessarily as a stand-alone bank.
Senator Brown. Thank you. Last question. Professor Schwarcz
raised concerns about systemic risk from insurers. His article
highlights two specific activities that AIG engaged in:
derivatives dealing and securities lending. Dodd-Frank imposes
new regulations on derivatives. The CFTC is, as we know,
implementing those for securities lending. Dodd-Frank gives
FSOC the authority to regulate both entities, and activities--
activity-based regulation is still in its early stages.
Governor Tarullo of the Fed has proposed applying universal
margin requirements to all securities financing transactions.
So, Mr. Cohen and Mr. Klein and Professor Schwarcz, if you
would just answer a couple of questions. Does FSOC have the
tools to address the issues that Professor Schwarcz raised?
And, second, do you agree with Governor Tarullo's proposal as
far as it goes now? And start with Mr. Cohen, then Mr. Klein,
then Mr. Schwarcz, if you would.
Mr. Cohen. Senator, I do believe that the tools exist,
through FSOC, through the Federal Reserve, to regulate on an
activity or product basis. Whether or not this should take the
form of increased margin requirements, which really is a
macroeconomic approach rather than a micro, institution-
specific approach, I think we just need to see what the Federal
Reserve is going to propose here.
Senator Brown. Mr. Klein?
Mr. Klein. I think, Mr. Chairman, the FSOC does have the
tools to address it. It is critically important that they do.
Activities-based regulatory authority was one of the major
advancements, in my opinion, in Dodd-Frank. There has been a
lot of focus spent on regulating institutions. It is what
regulators know to do. But activities is fundamentally where
problems tend to arise before they end up in institutions. And
so I think they do have the tools. I think they ought to use
them more.
I also think Professor Schwarcz was right to point out with
AIG, during my time looking into their secured lending
facility, there were significant problems there. It did
highlight a weakness in the State-based insurance regulatory
system, one of the reasons an optional Federal charter may make
sense.
With regard to the point on Governor Tarullo on the margin
requirements, I think it is still a little bit too early to
tell if that is the right approach, but I think he and the Fed
ought to be commended for pushing FSOC and going down the
activities-based regulatory approach.
Senator Brown. Professor Schwarcz, your last word.
Mr. Schwarcz. Sure. Two things.
The first is I think that the Fed does have the appropriate
authority with respect to insurers that are designated as
``systemically risky.'' I actually believe that there is
systemic risk in the insurance industry that may not be
captured by that. So, for instance, the recent report of the
FIO pointed out mortgage insurers, and to me it does not make
sense that mortgage insurers are regulated by States.
I also tend to think that it is true that we need a
stronger, more robust Federal presence with respect to other
systemic risks in the industry. I do not think the designation
power is enough, and I go through that in the article.
The final thing I just want to say is I am wary--and I just
want to emphasize this again. We have been conflating the SIFI
issue and the issue of bank holding companies and savings and
loan holding companies. Those are bank holding companies and
savings and loan holding companies. And I do have concern with
some of the legislative solutions that it could create
regulatory arbitrage by saying certain bank holding companies
or savings and loan holding companies can avoid the regulation
intended for bank holding companies and savings and loan
holding companies if they engage in insurance. That could
encourage them to increase their insurance business, encourage
them to create an uneven playing field among different types of
bank holding companies and savings and loan holding companies.
So while my testimony for the most part was focused on
insurance SIFIs, I just want to be clear, I think the issues
are different for bank holding companies and savings and loan
holding companies. And I think that some of the legislation,
frankly, does not deal with that issue as well as I would like
it to.
Senator Brown. Well, thank you, Professor Schwarcz. Thanks
to all five of you. If Members of the Subcommittee have
questions they submit in writing, please answer them within 7
days, get them back; or if you want to do any addenda to your
testimony or your comments, we would appreciate that.
I have statements submitted from the Property Casualty
Insurers Association, the American Council of Life Insurers,
the National Association of Mutual Insurance Companies, the
American Insurance Association, the United States Chamber of
Commerce, the National Association of Insurance Commissioners,
a statement by the Financial Services Roundtable, and a letter
from former Federal Deposit Insurance Corporation Chair, Sheila
Bair, and I ask unanimous consent that they be entered into the
record.
I thank all of you, Senator Johanns, especially thank all
of you for joining us today.
The hearing is adjourned.
[Whereupon, at 11:34 a.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow]:
PREPARED STATEMENT OF GINA WILSON
Executive Vice President & Chief Financial Officer
TIAA-CREF
March 11, 2014
I. Introduction
Chairman Brown and Ranking Member Toomey, Members of the
Subcommittee, thank you for providing TIAA-CREF with the opportunity to
testify on a very important issue to both TIAA-CREF and the clients we
serve.
Our testimony today focuses on the final rules governing capital
standards and the Basel III accords issued by the Federal Reserve Board
(``FRB'') in conjunction with the Office of the Comptroller of Currency
(``OCC''), and the Federal Deposit Insurance Corporation (``FDIC'')
(collectively the ``Agencies'').\1\ The final rule contained a number
of changes from the proposed rulemaking, most notably it temporarily
exempted bank holding companies subject to the FRB's Small Bank Holding
Company Policy Statement and Savings and Loan Holding Companies
(``SLHCs'') substantially engaged in insurance underwriting or
commercial activities. In statements accompanying the final rule, the
FRB indicated that the temporary exemption for insurance SLHCs was
provided in recognition of policy concerns expressed regarding the
imposition of bank capital rules on insurance companies.
---------------------------------------------------------------------------
\1\ 12 CFR Parts 208, 217, and 225. Regulatory Capital Rules:
Regulatory Capital, Implementation of Basel II, Capital Adequacy,
Transition Provisions, Prompt Corrective Action, Standardized Approach
for Risk-Weighted Assets, Market Discipline and Disclosure
Requirements, Advanced Approaches Risk-Based Capital Rule, and Market
Risk Capital Rule; Final Rule.
---------------------------------------------------------------------------
We appreciate the temporary exemption and its acknowledgment that
the insurance business model is quite different from the banking model.
However, given the FRB's public statements regarding their current
interpretation of the Collins Amendment, we are concerned that any
final rule will impose Basel III on insurance companies with only
modest and incomplete adjustments from the proposed rule.
II. Background
TIAA-CREF is a leading provider of retirement services in the
academic, research, medical and cultural fields managing retirement
assets on behalf of 3.9 million clients at more than 15,000
institutions nationwide.\2\ The mission of TIAA-CREF is ``to aid and
strengthen'' the institutions we serve by providing financial products
that best meet the needs of these organizations and help their
employees attain financial well-being. Our retirement plans offer a
range of options to help individuals and institutions meet their
retirement plan administration and savings goals as well as income and
wealth protection needs.
---------------------------------------------------------------------------
\2\ As of December 31, 2013.
---------------------------------------------------------------------------
TIAA-CREF is comprised of several distinct corporate entities.
Teachers Insurance and Annuity Association of America (``TIAA''),
founded in 1918, is a life insurance company domiciled in the State of
New York operating on a nonprofit basis with net admitted general
account assets of $232 billion.\3\ TIAA is a wholly owned subsidiary of
the TIAA Board of Overseers, a special purpose New York not-for-profit
corporation. The College Retirement Equities Fund (``CREF'') issues
variable annuities and is an investment company registered with the
Securities and Exchange Commission (``SEC'') under the Investment
Company Act of 1940. TIAA-CREF also sponsors a family of equity and
fixed-income mutual funds.
---------------------------------------------------------------------------
\3\ As of January 31, 2014.
---------------------------------------------------------------------------
While we are primarily engaged in the business of insurance, TIAA
and the Board of Overseers hold a small thrift institution within their
structure and as a result are registered as SLHCs. This thrift provides
TIAA-CREF with the ability to offer our clients deposit and lending
products integrated with our retirement, investment management and life
insurance products and enhances our ability to help them attain
lifelong financial well-being.
Our status as a SLHC places us under the purview of the FRB and
consequently subjects us to the proposed regulatory capital regime the
Agencies have set forth. TIAA-CREF supports ongoing progressive
financial regulation, including strong and appropriate capital
standards that are consistent with SLHCs' operating models and the
risks inherent in their business. It is equally important, however, to
ensure the standards ultimately implemented by the Agencies fully
account for the diverse business models under which different financial
services organizations operate. In our analysis of the rules through
the prism of a firm predominantly engaged in insurance, we have found
the Agencies have taken a bank-centric approach with the final rule.
Consequently, this approach does not account for the significant
differences between insurers who hold thrifts, but maintain the
overwhelming majority of their business in insurance products
(``insurance-centric SLHCs''), and those firms that are primarily
banking entities.
To be clear, we support appropriate capital regulations for banking
organizations and are not seeking to exempt insurers from the tenets of
the Dodd-Frank Act (``DFA''). Nevertheless, applying metrics designed
for banks to an insurer would be inappropriate and could have a number
of negative effects for insurers, customers, and the economy as a
whole. TIAA-CREF is particularly concerned about the effects of the
rule on our ability to continue providing our clients with a full menu
of appropriate and reasonably priced financial services products.
The FRB can use the flexibility permitted by the DFA to tailor
capital standards for the insurers that they oversee, which is key to
resolving most of the potential negative repercussions that may result
from imposing a bank-focused capital regime on insurance companies.
The FRB has taken the position that Section 171 of DFA (the
``Collins Amendment''), which requires regulators to establish risk-
based capital standards for banking organizations, prohibits the FRB
from treating insurance assets differently from banking assets. We, as
well as many of our peers, do not share this legal interpretation and
instead believe the Collins Amendment provides banking regulators with
the necessary flexibility to account for and integrate the existing
U.S. insurance regulatory capital regime when developing their new
model.\4\
---------------------------------------------------------------------------
\4\ Comment letter on Regulatory Capital Rules: 1 77 F.R. 52792
(Aug. 30, 2012); 77 F.R. 52888 (Aug. 30, 2012); 77 F.R. 52978 (Aug. 30,
2012), Submitted by Chief Financial Officers of Country Financial,
Mutual of Omaha, Nationwide Mutual Insurance Company, Principal
Financial Group, Prudential, TIAA-CREF, USAA, Westfield Group, October
22, 2012.
---------------------------------------------------------------------------
III. Congressional Intent and the Collins Amendment
Congress clearly demonstrated throughout the DFA legislative
process, and in the text of various provisions within DFA, its intent
to allow insurance-centric SLHCs to continue to own thrifts and offer
their customers banking products and services. During consideration of
the DFA, Congress affirmed the importance of the SLHC structure by
maintaining the thrift charter, ensuring SLHCs would not need to become
Bank Holding Companies (``BHCs''), and maintaining the Gramm-Leach-
Bliley (``GLB'') grandfather provisions for nonbank activities of
certain SLHCs and the qualified thrift lender (``QTL'') test for SLHCs.
Congress went so far as to instruct the FRB to:
. . . take into account the regulatory accounting practices
and procedures applicable to, and capital structure of, holding
companies that are insurance companies (including mutuals and
fraternals), or have subsidiaries that are insurance
companies'' in determining SLHC capital standards.\5\
\5\ Senate Report 111-176 at footnote 161 (April30, 2010)--
discussion of Section 616 amending HOLA to clarify the FRB's authority
to issue capital regulations for SLHCs where the Committee specifically
notes:
It is the intent of the Committee that in issuing regulations
relating to capital requirements of bank holding companies and savings
and loan holding companies under this section, the Federal Reserve
should take into account the regulatory accounting practices and
procedures applicable to, and capital structure of, holding companies
that are insurance companies (including mutuals and fraternals), or
have subsidiaries that are insurance companies.'' [emphasis added].
Indeed, as demonstrated by the original Volcker Rule provisions in
the DFA that created a number of insurance exemptions, Congress
expected insurance companies to continue to own thrifts.\6\ By taking
these steps, Congress also confirmed that the public is entitled to
more, not less, competition in the banking industry. Unfortunately, the
application of the Basel III Capital Rules would make continued
ownership of thrifts by insurance organizations economically
prohibitive, effectively accomplishing through regulation what Congress
not only did not intend to do by statute,\7\ but what Congress
specifically directed the FRB to avoid doing.
---------------------------------------------------------------------------
\6\ Section 619(d)(1)(F) of the DFA.
\7\ ``Dodd-Frank Amps Insurers for Banking Exit,'' SNL Financial
(July 11, 2012).
---------------------------------------------------------------------------
The Collins Amendment requires banking regulators to establish
minimum risk-based and leverage capital requirements on a consolidated
basis for insured depository institutions, depository institution
holding companies and nonbank financial companies supervised by the FRB
(collectively, ``Covered Companies''). However, nowhere in the language
of the Collins Amendment is there a directive to ignore the differences
between insurance companies and banks. Rather, the language only
requires that the risk-based and leverage capital requirements
applicable to covered companies shall not be:
1) Less than the generally applicable risk-based capital and
leverage capital requirements, which shall serve as a floor for
any capital requirements that the Agencies may require (``Bank
Standard''); or
2) Quantitatively lower than the generally applicable risk-based
capital and leverage capital requirements that were in effect
for insured depository institutions as of the date of enactment
of the DFA (``2010 Regulations'').\8\
---------------------------------------------------------------------------
\8\ Section 171(b)(1) of the DFA.
The Collins Amendment did not intend for banking regulators to
ignore the differences between banks and insurance companies in
formulating the capital standards for banking entities, nor for the
standards applicable to other Covered Companies. In a letter to the
Agencies on the proposed rules implementing capital standards, Senator
Susan Collins (R-ME) stated, ``it was not Congress's intent that
Federal regulators supplant prudential State-based insurance regulation
with a bank-centric capital regime.''\9\ Rather, the Bank Standard
outlined in Section 171(a)(2) of the Collins Amendment, which sets a
floor for SLHC risk-based capital standards, allows the FRB to
specifically address insurance activities. The requirement of Section
171(b)(2) sets the ``generally applicable risk-based capital
requirements'' floor and does not require an asset-by-asset testing of
risk-weights.\10\ Instead, the requirement speaks to a ``numerator'' of
capital, a ``denominator'' of risk-weighted assets and a ratio of the
two. The Collins Amendment also does not require asset-by-asset or
exposure-by-exposure minimum requirements, but instead calls for
holistic floors. The second requirement that the standards not be
quantitatively lower than the 2010 Regulations can be satisfied by
either following the terms of the 2010 Regulations or through a
holistic quantitative analysis of equivalence with appropriate capital
standards, which would meet the ``not less than'' language of the
statute.
---------------------------------------------------------------------------
\9\ Letter to Agencies regarding proposed rulemaking for capital
standards from Senator Susan Collins (R-ME), November 26, 2012.
\10\ U.S. Senate Committee on Banking, Housing and Urban Affairs,
``Oversight of Basel III: Impact of Proposed Capital Rules,'' Statement
of Michael S. Gibson, Director, Division of Banking Supervision and
Regulation, Board of Governors of the Federal Reserve System, November
14, 2012.
---------------------------------------------------------------------------
The FRB has stated publicly before the Committee and others that
the business of insurance is different than that of banking, but the
Collins Amendment ties their hands in addressing these differences.
They believe the language imposes a consistent set of asset specific
risk-weights for all covered companies. We have expressed to the FRB,
both in person and in our comment letter (see Appendix A),\11\ our view
that the language of the Collins Amendment provides adequate
flexibility to interpret the statute in a way that permits them to
account for the differences between banking and insurance. This point
of view is validated by nine leading law firms, which sent a letter to
the Agencies concurring with our interpretation of the Collins
Amendment (see Appendix B).\12\
---------------------------------------------------------------------------
\11\ See Appendix A. Comment letter to Agencies on Regulatory
Capital Rules, Brandon Becker, Executive Vice President and Chief Legal
Officer, TIAA-CREF, October 22, 2012.
\12\ See Appendix B. Comment Letter and Cover to Agencies on
Regulatory Capital Rules, Signed by attorneys specializing in
regulatory advice to insurance companies from Arnold & Porter LLP,
Gibson, Dunn & Crutcher, Venable, Wachtell, Lipton, Rosen & Katz,
Winston & Strawn LLP, Shearman & Sterling, LLP, Dechert LLP, Debevoise
& Plimpton LLP, and Paul Hasting LLP, March 20, 2013.
---------------------------------------------------------------------------
Consequently, we support and applaud the efforts of Senators
Sherrod Brown (D-OH) and Mike Johanns (R-NE) in introducing S. 1369
(Brown-Johanns), legislation to address the potential imposition of
banking capital rules on insurance companies under the Collins
Amendment. The Brown-Johann's bill would clarify that the Collins
Amendment does not require the FRB to impose a banking capital regime
by exempting insurers from the Collins Amendment, while leaving intact
the FRB's other sources of legal authority to impose robust capital
standards on federally supervised insurance companies. In addition,
under Brown-Johanns, Basel III bank-centric capital standards would
appropriately apply to any depository institutions owned by an
insurance company. We strongly support this legislation and look
forward to being part of the dialogue as the bill makes its way through
the Senate.
IV. Macro-economic effects of the application of the Basel III
standards on insurers
Bank-centric capital standards, which do not effectively recognize
the long dated nature of insurance activities, would likely encourage
insurers to modify certain practices and strategies that would be
detrimental to their core activities. Fundamentally, banks' core
business is lending and maturity transformation. As a result, insurers'
investment portfolios involve duration matching of assorted longer term
liabilities. That is, insurers match their long-term liabilities with
long-term investments. There are a number of distinct features that
differentiate banks from insurers, including:
1) Stable illiquid liabilities. The stability of life insurance
liabilities and their relative illiquidity is a fundamental
difference from banking deposit liabilities.
2) Long-term savings and asset protection products. Insurance
products serve long-term savings and asset protection goals,
which are fundamentally different from the objectives of bank
depositors.
3) Long duration assets. Based on the long-term nature of their
liability structure, insurance companies invest for a longer
duration than banks.
4) Adverse Deviation. The business of insurance is built on sound,
well tested and proven actuarial science. Reserves are based on
assumptions that are reasonably conservative and include
provisions for the risk of unfavorable deviation from such
assumptions (i.e., mortality, interest rates, withdrawals, and
expenses). Insurers apply this discipline to a large range of
uncertain events in their long dated portfolios.
5) Source of long-term funding for the economy. Insurance companies
are a significant source of long-term, stable funding for the
corporate, real estate, and governmental sectors of the
economy, while banks are primarily a source of short-term
financing to these sectors.
Imposing a capital framework designed to address the maturity
mismatch inherent to banking on an insurer would create an investment
portfolio construction challenge where none previously existed. Under
the Rules, certain long-term investments, which are typically less
liquid than shorter-term investments, are discouraged. Because the
Basel III capital framework focuses substantially on assets, rather
than taking a holistic approach, it does not consider the importance of
matching the duration of assets and liabilities. To ignore the
fundamental importance of this concept challenges an insurer's ability
to properly consider one of the most important elements of insurer risk
management. The application of enhanced bank-focused standards as
outlined in the Rules, without considering the existing strict capital
rules to which insurers already adhere, would have a number of negative
effects for TIAA-CREF and other insurance-centric SLHCs including:
1) Adherence to two regulatory reporting structures which have very
different incentives surrounding liquidity and consumer
protection;
2) Greater costs for insurance products;
3) Pressures on insurance reserve conservatism to meet bank
definitions of capital; and
4) Recording unrealized gains/losses causing short term strategic
capital management incentives.
Simply put, applying bank capital standards to an insurer would
create a disincentive to invest in the very assets that most promote
stability and solvency.
V. Conclusion
The Rules set forth by the Agencies, if applied to insurers, would
have a detrimental effect on the insurers' ability to offer affordable
financial products, which would in turn trickle down to individuals who
utilize insurance products to help them build a secure financial
future. The Rules also could have macroeconomic implications that, for
example, would create disincentives for insurers to invest in asset
classes that promote long-term economic growth such as long-term
corporate bonds, project finance and infrastructure investments,
commercial real estate loans, private equity and other alternative
asset classes.
Strong capital standards are vital to strengthening the overall
structure of the U.S. financial system. The existing capital regime
under which insurers operate has served the industry well and proved
extremely effective when put to the test during the recent financial
crisis. We are confident the FRB can develop alternative proposals to
ensure a strong capital regime that also accounts for the business of
insurance. Indeed, in our comment letter to the FRB and in our
subsequent conversations with them, we have proposed alternative
methodologies for measuring an insurer's capital that support both the
policy goals of the FRB and ensure a strong capital regime, while also
accounting for the business of insurance. We hope as they continue to
study the issue, regulators will find a sensible way to integrate a
capital structure appropriately designed for insurers. In the meantime,
we ask Congress to explicitly give the Agencies the ability to ensure
capital standards are appropriately tailored for insurers.
Thank you again for the opportunity to testify. Given the potential
affect the Rules could have on our business and our clients, we have
been very active in our efforts to educate policymakers about our
concerns and will continue to leverage all opportunities made available
to us. We appreciate the Subcommittee taking an interest in this issue
and having afforded us another venue in which to discuss our concerns.
______
PREPARED STATEMENT OF DANIEL SCHWARCZ
Associate Professor and Solly Robins Distinguished Research Fellow
University of Minnesota Law School
March 11, 2014
Chairman Brown, Ranking Member Crapo, and Members of the
Subcommittee, thank you very much for this opportunity to discuss the
appropriate capital standards to be applied to firms that are
predominantly engaged in the business of insurance and subject to
Section 171 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank''). I hope to make three primary points in
this testimony, which draws substantially on a co-authored draft
article, Regulating Systemic Risk in Insurance.\1\ First, I will
emphasize that the business of insurance can create important systemic
risks to the larger financial system. The specific contours and
magnitudes of these systemic risks are constantly evolving based on
shifts in the insurance industry and its regulation. Second, I will
suggest that, as contemplated by Dodd-Frank, these risks warrant the
application of federally designed capital standards to nonbank
financial companies primarily engaged in the business of insurance that
the Financial Stability Oversight Council (``FSOC'') designates as
systemically risky (``Insurance SIFIs''). Unlike State risk-based
capital rules, which focus primarily on consumer protection, these
Federal capital standards should focus on the distinctive ways in which
Insurance SIFIs can pose systemic risk to the larger financial system.
This approach is perfectly consistent with Section 171. Third, I will
caution against exempting bank/thrift holding companies from Section
171 simply because they or a large number of their subsidiaries are
subject to State insurance capital requirements.
---------------------------------------------------------------------------
\1\ See Daniel Schwarcz & Steven L. Schwarcz, Regulating Systemic
Risk in Insurance (March 4, 2014), available at http://ssrn.com/
abstract=2404492 (arguing that systemic risk in insurance can arise due
to correlations among individual insurers with respect to both their
interconnections with the larger financial system and their
vulnerabilities to failure, and that the Federal Insurance Office
should consequently be empowered to supplement or preempt State law
when States have failed to satisfactorily address gaps or deficiencies
in insurance regulation that could contribute to systemic risk).
---------------------------------------------------------------------------
(1) Systemic Risk in Insurance
As exemplified by the dramatic failures of American Insurance Group
(``AIG'') and various financial guarantee insurers, insurance companies
and their affiliates played a central role in the 2008 Global Financial
Crisis.\2\ It is now generally accepted that insurers and their
affiliates that effectively provide insurance against the default of
financial instruments--whether through formal insurance policies (as in
the case of financial guarantee insurers) or through derivatives such
as credit default swaps (as in the case of AIG)--can contribute to
systemic risk.\3\ Other ``nontraditional'' insurance activities, such
as extensive use of securities lending (as in the case of AIG),\4\ or
mortgage guarantee insurance \5\ can also prove systemically risky.\6\
---------------------------------------------------------------------------
\2\ Additionally, two holding companies principally engaged in the
business of insurance received Federal funding in the midst of the
financial crisis though the U.S. Department of the Treasury's Troubled
Asset Relief Program. The Hartford Financial Services Group received
$3.4 billion and Lincoln National Corporation received $950 million.
Government Accountability Office, Insurance Markets: Impacts of and
Regulatory Response to the 2007-2009 Financial Crisis (June 2013).
\3\ The Geneva Association, Cross Industry Analysis, 28 G-Sibs Vs.
28 Insurers, Comparison of Systemic Risk Indicators (Dec. 11, 2012).
\4\ A substantial contributor to AIG's woes was its securities
lending program, which, while coordinated by a noninsurer affiliate of
AIG, exploited securities owned by AIG's insurers. See William K.
Sjostrom, Jr, The AIG Bailout, 66 Wash. & Lee L. Rev. 943 (2009).
\5\ Federal Insurance Office, How to Modernize and Improve the
System of Insurance Regulation in the United States, (December 2013)
(suggesting the need for Federal regulation of the mortgage insurance
industry).
\6\ See J. David Cummins & Mary A. Weiss, Systemic Risk and the
U.S. Insurance Sector (2011), available at http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=1725512.
---------------------------------------------------------------------------
But in the last several years, a narrative has emerged suggesting
that these risks are vanishingly small. This argument emphasizes that
very few traditional insurers actually failed during the financial
crisis.\7\ It also stresses that AIG Financial Products--the division
of AIG that was principally responsible for writing the credit default
swaps that were the primary (though not sole) source of the company's
problems--was not regulated as an insurance company, in large part due
to Federal law.\8\ Finally, it argues that insurers, unlike banks, do
not have a mismatch in their assets and liabilities.
---------------------------------------------------------------------------
\7\ Government Accountability Office, Insurance Markets: Impacts of
and Regulatory Response to the 2007-2009 Financial Crisis (June 2013).
\8\ See American International Group: Examining What Went Wrong,
Government Intervention, and Implications for Future Regulation: 110th
Cong. (2009) (Statement of Eric Dinallo, Superintendent New York State
Insurance Department).
---------------------------------------------------------------------------
This narrative, however, ignores important linkages between the
insurance industry and the rest of the financial system as well as
insurers' potential vulnerabilities to catastrophic events. Although
the insurance industry is indeed less systemically risky than the
banking and shadow banking sectors, it is also structurally capable of
posing a variety of systemic risks to the larger financial system.
Perhaps even more importantly, the magnitude and character of these
risks are themselves constantly evolving and shifting. A decade ago,
the notion that a company within an insurance group could threaten the
global financial system through its portfolio of credit default swaps
would have been viewed--perhaps accurately, at the time--as
preposterous. The lesson is that the regulation of systemic risk in
insurance must be designed to proactively identify, assess, and manage
new potential sources of systemic risk in the industry. With this in
mind, consider several specific ways in which insurers could
potentially threaten the stability of the broader financial system.
Demand for Assets that Spread Systemic Risk: Insurers are among the
largest and most important institutional investors domestically and
internationally.\9\ They own approximately one-third of all investment-
grade bonds and, collectively, own almost twice as much in foreign,
corporate, and municipal bonds than do banks. Their holdings of
corporate and foreign bonds exceed those of mutual funds and pension
funds combined.
---------------------------------------------------------------------------
\9\ This is much more true of the life insurance industry than the
property/casualty insurance industry. Accordingly, commentators are
likely correct that the former poses more systemic risk than the
latter. See, e.g., Steven Weisbart & Robert P. Hartwig, 2011, Property/
Casualty Insurance and Systemic Risk (2011).
---------------------------------------------------------------------------
Insurers' massive role as investors in financial instruments does
not just mean that they can be passive victims of financial
instability. Financial markets, as with all markets, are impacted both
by supply side forces and demand-side forces. Thus, when insurers
collectively demand certain types of financial assets, the amount
supplied and prices of these assets will increase. In fact, recent
evidence shows the insurance industry played a major role in stoking
demand for mortgage-backed securities and related instruments in the
years leading up to the financial crisis.\10\ By 2007, life insurers
held approximately $470 billion in these securities, accounting for
about 25 percent of the total market. Their demand for these securities
skyrocketed in the years preceding the crisis, in large part due to
unrealized losses in variable annuity products and State capital
standards that treated highly rated structured securities as very low
risk.
---------------------------------------------------------------------------
\10\ Craig Merrill, Taylor D. Nadauld, & Philip Strahan, Final
Demand for Structured Finance Securities, (Working Paper, January 17,
2014) available at http://ssrn.com/abstract=2380859. For evidence that
insurers can play a similar role in misallocating credit in corporate
bond markets, see Bo Becker, & Victoria Ivashina, Reaching for Yield in
the Bond Market, Journal of Finance (forthcoming), available at http://
www.hbs.edu/faculty/Publication%20Files/12-103_c2425c59-1647-42df-8d1b-
7b8ed433fb76.pdf.
---------------------------------------------------------------------------
Insurers were thus substantially responsible for fueling the demand
for structured finance securities. And, of course, the explosion in
these instruments has been blamed for indirectly helping to fuel the
pre-crisis housing bubble.\11\ Notably, insurers' contribution to
systemic risk in this example occurred even though the terms of their
assets and liabilities were well matched and most of them ultimately
avoided failure.
---------------------------------------------------------------------------
\11\ Facing substantial demand to originate mortgages so that they
could be packaged together and securitized, banks and other mortgage
originators increasingly loosened credit standards, allowing more and
more people to buy houses with loans they ultimately could not afford.
See Kathleen Engel & Patricia McCoy, the Subprime Virus: Reckless
Credit, Regulatory Failure, and Next Steps (2011).
---------------------------------------------------------------------------
Asset Fire Sales: Insurers' massive role as institutional investors
also means that they can pose systemic risks by triggering or
exacerbating a ``fire sale'' of specific securities or types of
securities.\12\ Emerging evidence suggests that insurers did stoke fire
sales in mortgage-backed securities and related instruments in 2008,
when many insurers attempted to sell these securities in response to
regulatory, rating agency, and market pressures.\13\ In offloading
these securities in a coordinated fashion, insurers contributed to the
sudden illiquidity of these instruments, causing unrelated financial
institutions holding these or similar assets to face tremendous
liquidity pressures. Indeed, the inability of firms to sell or price
such ``toxic assets'' was the key reason for the failure or near
failure of numerous banks and investment banks, including Lehman
Brothers.\14\
---------------------------------------------------------------------------
\12\ Andrew Ellul, Chotibhak Jotikasthira, & Christian T. Lundblad,
Regulatory Pressure and Fire Sales in the Corporate Bond Market, 101 J.
Financial Econ. 596 (2011).
\13\ Craig B. Merrill, Taylor D. Nadauld, Rene M. Stulz, & Shane
Sherlund, Did Capital Requirements and Fair Value Accounting Spark Fire
Sales in Distressed Mortgage-Backed Securities?, NBER Working Paper No.
18270 (Aug. 2012), available at http://www.nber.org/papers/w18270;
Andrew Ellul, Pab Jotikasthira, Christian T. Lundblad, Yihui Wang et
al., Is Historical Cost Accounting a Panacea? Market Stress, Incentives
Distortions, and Gains Trading (NYU Working Paper, 2012), available at
http://ssrn.com/abstract=1972027.
\14\ National Commission on the Causes of the Financial and
Economic Crisis in the United States, the Financial Crisis Inquiry
Report (2011).
---------------------------------------------------------------------------
As above, insurers' seeming role in contributing to fire sales of
mortgage-backed securities occurred notwithstanding the matching of
their assets and liabilities or their ultimate avoidance of failure.
Ironically, insurers' very success in limiting their exposure to
``toxic assets'' in the early stages of the crisis, and thus
safeguarding their own financial strength, may have actually
exacerbated the liquidity troubles of unrelated firms. But just like
the first people in line during a run on a bank, while insurers may
have gotten through the financial crisis relatively unscathed, that
does not mean that they were not instrumental in causing the crisis in
the first place.
Simultaneous Failure of Several Large Insurers: Although insurers
need not fail in order to contribute to systemic risk, the converse is
not true: substantial failures of several large insurers could well
disrupt the financial system as a result of insurers' status as massive
investors. In certain cases, an insurance company could be required to
quickly liquidate a substantial portion of its portfolio.\15\ This
might occur if it failed due to a catastrophic event triggering an
unmanageable numbers of claims, a failure of a reinsurer, or a ``run''
on products that permitted policyholders to withdraw funds or take out
loans against their policy. If many insurers simultaneously experienced
this type of distress, this could trigger, or exacerbate, the types of
distortions in capital markets that were witnessed in 2008.
---------------------------------------------------------------------------
\15\ Of course, there are also cases in which an insurance
company's failure does not result in an immediate need for the company
or its receiver to liquidate much of its portfolio. See Insurance
Oversight and Legislative Proposals: Testimony Before H. Fin. Subcomm.
on Ins., Hous. and Cmty. Opportunity, 112th Cong. 9 (2011) (Statement
of Peter Gallanis, National Organization of Life and Health Insurance
Guaranty Associations) available at https://www.nolhga.com/pressroom/
articles/HFSCnolhgaTestimonyNov15_2011.pdf.
---------------------------------------------------------------------------
The failure of several large insurers is hardly unimaginable.\16\
Insurers are potentially subject to a wide array of catastrophe risks
that could trigger a wave of claims across numerous insurers within a
short timeframe. And while insurers attempt to safeguard against such
risks through policy exclusions, reinsurance, and other risk-management
techniques, these efforts are hardly fail-safe. For instance, prior to
9/11, commercial property insurance policies did not contain any
explicit exclusion for terrorism insurance and insurers did not even
include this risk in their calculations of premiums. After 9/11,
insurers insisted that terrorism risk was so large and incalculable
that they could not provide coverage at all, at least without an
explicit Federal backstop.\17\ Similarly, life insurers face
potentially massive exposure to a global pandemic such as the Flu of
1918, which killed between 20 and 40 million people within a single
year.
---------------------------------------------------------------------------
\16\ For instance, in 1991 six major life insurers, each with over
$4 billion in assets, failed as a result of their common exposures to
commercial real estate and junk bonds. See Scott Harrington,
Policyholder Runs, Life Insurance Company Failures, and Insurance
Solvency Regulation, 15 Regulation 27 (1992).
\17\ Although the massive losses that insurers incurred in
connection with 9/11 did not substantially destabilize the industry,
insurers' sudden and dramatic shift in their willingness to provide
this coverage suggests that they might well have had events transpired
differently or had they occurred at the same time as preexisting
financial instability.
---------------------------------------------------------------------------
Interconnectedness through Reinsurance: Although insurers attempt
to manage catastrophe risk through reinsurance arrangements, the
reinsurance industry itself is potentially subject to catastrophe risk.
The reinsurance industry is extremely concentrated in a few massive
firms, such as Swiss Re, Munich Re, and Berkshire Hathaway. In 2009,
for instance, five reinsurance groups provided approximately 60 percent
of the world's reinsurance capacity.\18\ This concentration creates
deep interconnections among insurers, such that the failure of one or
two major reinsurers could simultaneously impact a substantial segment
of the insurance industry at once.\19\ This risk is exacerbated by the
fact that reinsurer financial strength is itself highly opaque, and
reinsurers often reinsure risks with one another, creating the
possibility that one reinsurer's failure could have a domino effect on
other reinsurers.\20\
---------------------------------------------------------------------------
\18\ International Association Of Insurance Supervisors,
Reinsurance And Financial Stability (July 2012).
\19\ See J. David Cummins & Mary A. Weiss, Systemic Risk and the
U.S. Insurance Sector (2011), available at http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=1725512 (``Reinsurance is the primary source of
interconnectedness within the insurance industry.'').
\20\ Group of Thirty, Reinsurance and International Markets (2006).
---------------------------------------------------------------------------
Exposure to Policyholder Runs: Despite their frequent protestations
to the contrary, life insurers are also not immune to the possibility
of a run on their products. While this is certainly much less likely
for life insurers than banks, a significant number of many life
insurers' policies are subject to early withdrawal and include a
significant cash surrender value.\21\ Growing competition from life-
settlement companies--which offer policyholders the option of selling
their policies for cash--will likely increasingly pressure life
insurers to allow policyholders to cash out of their policies with
smaller penalties. This, in turn, may make life insurers more
susceptible to the possibility of a policyholder run. So too might the
increasing trend among life insurers to make payouts through ``retained
asset accounts'' that function almost identically to bank accounts.\22\
The risk of a policyholder run is exacerbated by the fact that State
insurance guarantee funds do not generally fully guarantee the value of
most insurance policies, cannot be spread among companies or policies
to increase limits (unlike FDIC insurance), and are much less
financially credible than FDIC insurance as they are not pre-funded or
explicitly backstopped by the Federal Government.
---------------------------------------------------------------------------
\21\ See FSOC, Basis for the Financial Stability Oversight
Council's Final Determination Regarding Prudential Financial Inc.
(Sept. 19, 2013). The most substantial policyholder run on a U.S.
insurance company involved Executive Life, where policyholder cash
surrenders exceeded over $3 billion in the year prior to its failure.
Although this run was more a product of Executive Life's tenuous
financial position than the cause of its tenuous position, it did
indeed have the effect of forcing Executive Life to liquidate a
substantial percentage of its portfolio. See Scott Harrington,
Policyholder Runs, Life Insurance Company Failures, and Insurance
Solvency Regulation, 15 Regulation 27 (1992).
\22\ See Texas Department of Insurance, Retained Asset Accounts
Survey (2011), available at http://www.tdi.texas.gov/reports/life/
documents/raareport.pdf (finding in a survey of 160 life insurers open
retained asset accounts totaling $2.3 billion with respect to
policyholders living in Texas).
---------------------------------------------------------------------------
Systematic Under-Reserving: There is a real risk that insurers may
systematically underestimate reserves for certain types of policies or
losses. Indeed, a recent proposal by a subcommittee of the Financial
Research Advisory Committee noted that the ``cyclicality of the
insurance industry's profits between hard and soft markets implies
specific periods during which underpricing of risk becomes an industry-
wide phenomenon.''\23\ In the past, such systematic errors in reserving
have been limited in the life insurance domain, because life insurers
have historically faced rigid and conservative reserving rules for
their products.
---------------------------------------------------------------------------
\23\ See Financial Research Advisory Committee Research
Subcommittee, OFR Study on the Insurance Sector Recommendation,
available at http://www.treasury.gov/initiatives/ofr/about/Documents/
FRAC%20Research%20OFR%20Study%20on%20the%20Insurance%20Sector%20
Recommendation.pdf.
---------------------------------------------------------------------------
However, two recent, and related, developments suggest that this
longstanding history of conservative reserving in life insurance may
not extend into the future. First, in the last decade or so, life
insurers have increasingly used captive insurance companies to escape
regulatory rules governing reserve setting, a process that some have
referred to as ``shadow insurance.''\24\ Recent estimates conclude that
``shadow insurance reduces risk-based capital by 53 percentage points
(or 3 rating notches) and raises impairment probabilities by a factor
of four.''\25\ Second, State insurance regulation is currently
embarking on a fundamental change to its regulatory approach, which
would grant insurers broad discretion to use internal models to set
reserve levels. The extensively documented inability of Federal
regulators to fully understand financial firms' internal risk models
suggests that large scale errors in life insurer reserving could be a
problem in the future. This is particularly so given that State
regulators currently lack sufficient technical expertise or resources
to undertake a reasonable evaluation of these models on a firm-by-firm
basis.\26\
---------------------------------------------------------------------------
\24\ See NY Department of Financial Services, Shining a Light on
Shadow Insurance (June 2013). Traditionally, captive insurance was
simply a way for a traditional noninsurance company, such as Coca Cola
or GM, to self-insure its risks rather than purchase conventional
insurance. But life insurers realized that they could exploit the rules
governing captive insurers to avoid what they deemed to be
``excessive'' reserve requirements. To do this, the life insurer
transfers some of its risk to the captive insurer via a reinsurance
transaction. This transaction can reduce reserves because insurers do
not need to reserve against risks that are transferred to reinsurers
(even if they are affiliated). Meanwhile, captive insurers are subject
to a much looser set of solvency rules than ordinary insurers and can
generally choose their regulator among any of the States. According to
the New York Attorney General, ``shadow insurance . . . puts the
stability of the broader financial system at greater risk.'' See
Benjamin M. Lawsky, N.Y. Superintendent of Fin. Serv., Remarks at the
22nd Annual Hyman P. Minsky Conference on the State of the U.S. and
World Economies in New York City (April 18, 2013) available at http://
www.dfs.ny.gov/about/speeches_testimony/sp130418.htm.
\25\ See Ralph S.J. Koijen and Motohiro Yogo, Shadow Insurance
(NBER Working Paper No. 19568, (2013), available at http://
papers.ssrn.com/sol3/papers.cfm?abstract_id=2320921.
\26\ Federal Insurance Office, How to Modernize and Improve the
System of Insurance Regulation in the United States, (December 2013).
---------------------------------------------------------------------------
Ultimately, it is surely true that the insurance industry currently
poses less systemic risk than the banking sector or the shadow-banking
sector, as many commentators have emphasized.\27\ At the same time,
however, the insurance industry is a crucial and dynamic component of
the American and international financial system, a fact that has been
documented by various studies quantifying the connections between
insurers and the rest of the financial system based on historical stock
prices and similar metrics.\28\ As such, the insurance industry can
indeed present a meaningful source of systemic risk that cannot be
easily limited to a pre-defined set of activities.
---------------------------------------------------------------------------
\27\ See Scott Harrington, The Financial Crisis, Systemic Risk, and
the Future of Insurance Regulation, 76 J. Risk & Ins. 785 (2009).
\28\ Monica Billioa, Mila Getmanskyb, Andrew W. Loc, & Loriana
Pelizzona, Econometric Measures of Connectedness and Systemic Risk in
the Finance and Insurance Sectors 104 J Fin. Econ. 535 (2012); Faisal
Balucha, Stanley Mutengab & Chris Parsons Baluch, Insurance, Systemic
Risk and the Financial Crisis, 36 The Geneva Papers 126 (2011); Viral
Acharya, Lasse Heje Pedersen, Thomas Philippon, & Matthew P.
Richardson, Measuring Systemic Risk (2010), available at http://
papers.ssrn.com/sol3/papers.cfm?abstract_id=1573171.
---------------------------------------------------------------------------
(2) Appropriate Capital Requirements for Insurance SIFIs
As contemplated by Dodd-Frank, Federal regulators should design,
implement, and regularly reassess distinct capital and leverage
standards for insurers that are particularly likely to pose systemic
risk, including Insurance SIFIs.\29\ A central tenet of federalism is
that regulatory responsibilities should be assigned, at least in part,
to the unit of government that best internalizes the full costs of the
underlying regulated activity.\30\ The rationale for this principle is
that government entities will only have optimal incentives to take into
account the full costs and benefits of their regulatory decisions if
the impacts of those decisions are felt entirely within their
jurisdictions. Given that systemic risk in insurance is a negative
externality whose effects are inherently felt nationally and
internationally, national and international regulatory bodies should
play a role in regulating insurance SIFIs.
---------------------------------------------------------------------------
\29\ Nonbank financial companies predominantly engaged in the
business of insurance and designated as systemically significant by
FSOC--which I label as Insurance SIFIs--are not necessarily the only
insurers who may pose systemic risks. For instance, mortgage insurers
may post systemic risks because of their prominent role in the housing
market. See Federal Insurance Office, How to Modernize and Improve the
System of Insurance Regulation in the United States, (December 2013).
Additionally, as I have argued elsewhere, entire segments of the
insurance industry may pose systemic risks because of correlations
among individual insurance companies with respect to both their
interconnections with the larger financial system and their
vulnerabilities to failure. For this reason, I believe that a broader
Federal role in regulating the insurance industry beyond that
established in Dodd-Frank is appropriate. See Daniel Schwarcz & Steven
L. Schwarcz, Regulating Systemic Risk in Insurance (March 4, 2014),
available at http://ssrn.com/abstract=2404492. But because Federal
regulation in these domains is not authorized by current law and is not
the subject of this hearing, I do not discuss these issues further in
the body of my testimony.
\30\ Wallace E. Oates, Fiscal Federalism (1972).
---------------------------------------------------------------------------
Federal involvement in designing capital requirements for Insurance
SIFIs is particularly important because State risk-based capital rules
are focused predominantly on consumer protection rather than systemic
stability.\31\ But the regulatory objective of a risk-based capital
regime has important implications for how that regime should be
constructed. In other words, capital regimes focused on systemic risk
can, and should, be designed differently than capital regimes focused
on consumer protection. Consider several examples of this important
point.
---------------------------------------------------------------------------
\31\ Thus, in a Report of the NAIC and the Federal Reserve Joint
Subgroup on Risk-Based Capital and Regulatory Arbitrage (2002), a
working group of insurance and banking regulators explained the core
differences between risk-based capital rules in insurance and banking
by noting that ``Insurance company regulators place particular emphasis
on consumer (policyholder) protection'' while ``banking regulators
focus on depositor protection and the financial stability of regulated
entities on a going concern basis.''
---------------------------------------------------------------------------
First, while a risk-based capital regime designed to address
systemic risk should focus on aggregate capital levels of an entire
holding company, a capital regime oriented toward consumer protection
can rely on entity-level capital regulation with strong ring-fencing
rules. Because of its consumer protection orientation, State insurance
regulation embraces the latter model: capital requirements are imposed
solely on individual legal entities, and regulators attempt to protect
these entities from affiliate or holding company risk. By contrast, a
capital regime focused on systemic risk demands group-wide capital
requirements. This is because risk-management, investment and business
strategies are all generally determined at the holding company
level.\32\ Group capital rules can also limit the prospect of other
problems that may have systemic consequences, such as double or
multiple gearing.\33\
---------------------------------------------------------------------------
\32\ See Elizabeth F. Brown, The New Laws and Regulations for
Financial Conglomerates: Will They Better Manage the Risks than the
Previous Ones?, 60 AM. U. L. REV. 1339 (2011).
\33\ Bank for Int'l Settlements, Principles for the Supervision of
Financial Conglomerates Consultative Document (2011). Double or
multiple gearing involves scenarios in which the same capital is used
as a buffer against risk by two entities at the same time, such that
the ``net'' solvency of the group is less than the sum of the capital
of the group's individual entities.
---------------------------------------------------------------------------
Second, a capital regime that is focused on systemic risk might
well be less dependent on credit-rating agencies in setting capital
charges for assets than would a capital regime focused on consumer
protection. Currently, State insurance regulation relies substantially
on rating agencies in determining capital charges for individual
assets.\34\ Recent changes in State rules regarding credit for
reinsurance also place a renewed regulatory emphasis on rating
agencies' assessments of reinsurers' financial strength.\35\ But as has
now been widely recognized, regulatory reliance on rating agencies can
increase systemic risk for a variety of reasons. It can lead to the
systematic underpricing of risk, dull the incentives of rating agencies
to correctly assess risk, and play a role in triggering fire sales by
producing coordinated investment decisions across a wide number of
firms. For these reasons, Dodd-Frank substantially limited reliance on
credit ratings by all Federal (but not State) regulators.\36\
---------------------------------------------------------------------------
\34\ Although State insurance regulation has limited its reliance
on private rating agencies in assessing structured finance vehicles, it
still relies enormously on private rating agencies to assess the
quality of insurers' assets. See John Patrick Hunt, Credit Ratings in
Insurance Regulation: The Missing Piece of Financial Reform, 68 Wash. &
Lee L. Rev. 1667 (2011).
\35\ Credit for Reinsurance Model Law, 2(b)-(c), adopted Nov. 6,
2011, available at http://www.naic.org/documents/
committees_e_reinsurance_related_docs_preface_adopted_ex_
plenary_111106.pdf.
\36\ Dodd-Frank Act 939A.
---------------------------------------------------------------------------
Third, a capital regime focused on systemic risk must be sensitive
to the possibility that it might inadvertently contribute to financial
instability. As described above, emerging evidence suggests that State
regulatory capital rules may have played a role in encouraging insurers
to both invest in mortgage-backed securities and to offload them when
they were downgraded (or when such downgrades were anticipated).
Although the literature on how, and when, capital rules and related
accounting standards can have inadvertent adverse effects on systemic
risk is still developing, systemic risk regulators must pay acute
attention to this issue.
Group-wide capital rules that limit their dependence on credit-
rating agencies and reduce distortions in firm behavior are thus
crucial for any capital regime that is principally oriented toward
guarding against systemic risk. But various more specific rules might
well be appropriate for capital regimes that are designed to guard
against systemic risk associated with insurance. For instance, such a
regime might well impose higher capital charges on long-term assets
with short-term volatility or deep illiquidity relative to an insurance
capital regime oriented only toward consumer protection. This is
because a central concern from the perspective of systemic risk is that
a systemically risky insurer could face sudden liquidity demands for a
variety of reasons notwithstanding insurers' usual matching of the
duration of their assets and liabilities. Such liquidity pressures
could stem from collateral calls associated with derivatives activities
or securities lending, mass policyholder withdrawals, a sharp increase
in claims due to catastrophe, or the failure of a reinsurer.
Similarly, a capital regime designed to guard against systemic risk
related to insurance might well resist some of the recent developments
that could weaken life insurer reserve practices. Thus, such a regime
could reject principles-based reserving in favor of the traditional
approach to setting life insurers' reserves, given the prominent role
that reliance on financial firms' own internal models for purposes of
setting capital played in triggering the 2008 financial crisis. Or, it
might restrict the credit that insurers can receive by using ``shadow
insurance'' to reduce their liabilities.
To be sure, capital requirements for Insurance SIFIs need not--and,
indeed, should not--mechanistically mirror the capital rules that are
applied to other types of financial firms. As emphasized in a recent
letter of Members of Congress, ``Strong capital standards need to be
consistent with the business models of the industry to which they are
applicable.''\37\ The systemic risks posed by Insurance SIFIs are both
different than, and likely less severe than, those posed by large bank
holding companies, and an appropriate capital regime for Insurance
SIFIs should reflect these facts. At the same time, an appropriate
capital regime for Insurance SIFIs should also reflect the fact that
the central goal of imposing capital requirements on these entities at
the Federal level is different than the goal of State capital
requirements. As such, the Federal capital regime applicable to
Insurance SIFIs cannot merely replicate or defer to the consumer
protection oriented State capital regime. Capital regimes should be
designed not only according to the industry to which they apply, but
also to the regulatory goal that they seek to achieve.
---------------------------------------------------------------------------
\37\ Letter from Members of Congress to Ben Bernanke, Chairman of
the Board of Governors of the Federal Reserve System (Dec. 11, 2012).
---------------------------------------------------------------------------
My understanding of Section 171--based on publicly available legal
analysis of the provision and several letters from Members of
Congress--is that it advances these goals. The provision gives the
Board of Governors of the Federal Reserve System (``Fed'') substantial
flexibility in determining how to calculate Insurance SIFIs' risk-based
capital and leverage limits so as to account for the particular risks
that these entities present.\38\ At the same time, it appropriately
seeks to ensure that, however these calculations are performed, they do
not fall below minimum levels.
---------------------------------------------------------------------------
\38\ Letter from H. Rodgin Cohen to Ricardo Anzaldua, Executive
Vice President and General Counsel of MetLife Inc., (May 20, 2013),
available at http://www.federalreserve.gov/SECRS/2013/May/20130523/R-
1438/R-1438_052313_111291_554506713029_1.pdf.; Letter from Members of
Congress to Ben Bernanke, Chairman of the Board of Governors of the
Federal Reserve System (Dec. 11, 2012).
---------------------------------------------------------------------------
(3) Appropriate Capital Requirements for Bank/Thrift Holding Companies
that Substantially Engage in the Business of Insurance
Bank and thrift holding companies have long been subject to Federal
capital and leverage requirements because of the unique risks
associated with owning an FDIC insured institution. Section 171
requires the Fed to ensure that these requirements are no less than
those applicable to ordinary small banks. This, in turn, helps to
ensure that holding companies of banks and thrifts do indeed serve as a
source of strength for their FDIC insured subsidiaries, as has long
been intended by the larger Federal banking regime. Proposed S. 1369
would exempt bank/thrift holding companies from the Section 171 floor
if they directly, or through their subsidiaries, derive a substantial
percentage of their consolidated revenues from the business of
insurance. This would be a mistake.
As discussed above, State insurance capital rules and bank/thrift
capital rules have fundamentally different regulatory objectives. While
the former focuses on protecting policyholders, the latter aims
principally to limit the exposure of taxpayers to bank failures and
minimize the prospect of systemic risk. And, as described above, these
different orientations have important implications for how the
corresponding capital regimes are, and should be, structured.
For these reasons, the fact that a holding company of a depository
institution is itself subject to State insurance capital requirements
or derives a substantial amount of its revenue from State-regulated
insurers does not mean that it should be exempted from the minimum
floors required by Section 171. Such an entity raises both the consumer
protection concerns that motivate State insurance regulation and the
systemic risk/taxpayer protection concerns that motivate the need for
capital/leverage rules for bank/thrift holding companies. It therefore
stands to reason that it should be subject to both sets of capital
rules, as well as to the Section 171 floor. Establishing a special rule
allowing certain bank/thrift holding companies to avoid Section 171
would not only create an uneven playing field, but it could encourage
regulatory arbitrage by allowing holding companies of FDIC insured
institutions to avoid regulatory requirements by increasing their
ownership of insurance entities or their own insurance activities.\39\
This, in turn, could have the effect of increasing the size of bank/
thrift holding companies.
---------------------------------------------------------------------------
\39\ An additional concern I have with proposed S. 1369 is that it
could have the effect of exempting a company from Section 171 on the
basis of activities that are not subject to State insurance capital
requirements. S. 1369 incorporates the definition of ``business of
insurance'' in Dodd-Frank: ``the writing of insurance or the reinsuring
of risks by an insurer, including all acts necessary to such writing or
reinsuring and the activities relating to the writing of insurance or
the reinsuring of risks conducted by persons who act as, or are,
officers, directors, agents, or employees of insurers or who are other
persons authorized to act on behalf of such persons.'' Dodd-Frank
1002. This definition is not explicitly tethered to State insurance
regulation, as is the proffered rationale for exempting bank/thrift
holding companies predominantly engaged in insurance from Section 171.
It therefore may be possible under proposed S. 1369 for a bank/thrift
holding company to avoid Section 171 on the basis of activities that
fall within this broad definition of insurance, but are not subject to
State capital requirements.
---------------------------------------------------------------------------
Exempting from Section 171 bank/thrift holding companies that
derive a substantial percentage of their revenue from insurance
operations but are not themselves regulated as insurance companies
would be particularly bad policy.\40\ As described above, the State
insurance capital regime does not apply to holding companies of
insurance entities. A bank/thrift holding company that derived a
substantial percentage of its revenue from the insurance operations of
its subsidiaries, but was not itself an operating insurance company,
would therefore not face any capital requirements at the holding
company level under State insurance law. There is consequently no
justification for providing such entities with a special exemption from
Section 171.
---------------------------------------------------------------------------
\40\ In the case of a bank/thrift holding company that was itself
regulated as an insurance company, State capital rules would apply to
the holding company entity. However, such regulation would still not
account for the distinctive risks associated with owning an FDIC
insured institution.
---------------------------------------------------------------------------
______
PREPARED STATEMENT OF H. RODGIN COHEN
Senior Chairman, Sullivan & Cromwell LLP
March 11, 2014
I. Introduction
Chairman Brown and Ranking Member Toomey, and distinguished Members
of the Subcommittee, I am honored to be with you today to discuss the
application of the capital standards in Section 171 of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (``Dodd-Frank'')\1\ to a
subset of insurance companies.\2\ Let me begin by commending you for
the leadership you have shown and for your efforts and attention to
this important issue.
---------------------------------------------------------------------------
\1\ Pub. L. No. 111-203 (2010).
\2\ Section 171 is codified at 12 U.S.C. 5371.
---------------------------------------------------------------------------
Section 171, which is commonly known as the ``Collins Amendment'',
after its primary sponsor, Senator Collins, establishes certain capital
standards for designated financial institutions. It is a part of Title
I, Subtitle C of Dodd-Frank, which includes enhanced prudential
standards and differentiation mandates in its principal provision,
Section 165. The insurance companies subject to Section 171, which I
will refer to as ``Covered Insurance Companies'', are either savings
and loan holding companies (``SLHCs'') or have been designated by the
Financial Stability Oversight Council (``FSOC'') for supervision by the
Board of Governors of the Federal Reserve System (``Federal Reserve'')
pursuant to Section 113 of Dodd-Frank.\3\
---------------------------------------------------------------------------
\3\ Sullivan & Cromwell represents Covered Insurance Companies and
other insurance companies.
---------------------------------------------------------------------------
Stated simply, the core question raised by the application of
Section 171 to Covered Insurance Companies is whether they should be
subject to the same capital framework as that which applies to banks
(which I will refer as the ``Bank Capital Framework'').
What is most striking about this question is that I do not know of
a single legislator or regulator, including the Federal Reserve, who
believes that, as a matter of policy, the Bank Capital Framework should
be automatically imposed on insurance companies. Nor do I know of a
single Member of Congress who maintains that Congress actually intended
to impose the identical capital regime on these two very different
businesses. As twenty-four Senators from both parties wrote to the
heads of the three Federal banking agencies on October 17, 2012:
``Congress did not intend for the Federal regulators to discard the
State risk-based capital system in favor of a banking capital
regime''.\4\
---------------------------------------------------------------------------
\4\ Letter to Ben. S. Bernanke, Martin J. Gruenberg and Thomas J.
Curry from Twenty-Four U.S. Senators (Oct. 17, 2012) (the ``October 17,
2012 Letter''). See also, a December 11, 2012 letter (the ``December
11, 2012 Letter'') from Thirty-Three Members of Congress of both
parties to former Chairman Bernanke which explained (in the context of
the Federal banking agencies' proposed rule to apply the Bank Capital
Framework to insurance companies) that ``[t]he bank-centric approach of
the proposed rules is inconsistent with the unique nature of insurance
and contradicts the intent of Congress.''
---------------------------------------------------------------------------
Senator Collins herself has made clear that it was not the intent
of Congress to ``supplant prudential State-based insurance regulation
with a bank-centric capital regime''.\5\ Instead, Senator Collins
explained, ``consideration should be given to the distinctions between
banks and insurance companies. I believe it is consistent with my
amendment that these distinctions be recognized in the final rule.''\6\
---------------------------------------------------------------------------
\5\ Letter to Ben S. Bernanke, Martin J. Gruenberg and Thomas J.
Curry from Senator Susan Collins (Nov. 26, 2012).
\6\ Id.
---------------------------------------------------------------------------
Accordingly, we are not debating what the result should be. Both as
a matter of policy and in terms of carrying out Congressional intent,
there should be tailored and differentiated capital requirements for
insurance companies. Instead, the question is how best to achieve that
result under Section 171.
My testimony today is divided into four parts. First, I will
summarize the terms of Section 171. Second, I will outline the relevant
policy issues. Third, I will attempt to explain why I believe that, as
a legal matter, the Federal Reserve already has sufficient authority to
deal appropriately with these issues. Fourth, in the event that the
Federal Reserve elects not to exercise that discretion, I will explain
briefly why Congressional action to deal with this matter is both
necessary and appropriate.
II. Section 171
Section 171 of Dodd-Frank does not prescribe specific capital
requirements, but provides two general mandates for both risk-based and
leverage capital requirements. First, the capital requirements applied
to companies subject to Section 171 may not be ``less than'' the
capital requirements applied to banks now or in the future. Second,
those requirements may not be ``quantitatively lower'' than the bank
capital requirements in place as of the date of the enactment of Dodd-
Frank. Presumably, the first mandate incorporates the so-called Basel
III capital framework, as implemented by the Federal banking agencies,
and the second mandate incorporates the Basel I capital framework, as
previously implemented by the agencies.
Section 171 is a part of Subtitle C of Title I of Dodd-Frank,
entitled ``Additional Board of Governors Authority for Certain Nonbank
Financial Companies and Bank Holding Companies''. The key operative
provision of Subtitle C is Section 165, which establishes ``enhanced
prudential standards'' for ``systemically important financial
institutions'', i.e., bank holding companies with total consolidated
assets of $50 billion or more (``BHC SIFIs'') and nonbank financial
companies designated by FSOC under Section 113 of Dodd-Frank for
supervision by the Federal Reserve (``Nonbank SIFIs'').\7\
---------------------------------------------------------------------------
\7\ Section 165 does not expressly apply to SLHCs. As discussed in
note 16 infra, however, the Federal Reserve has, in effect, made the
enhanced prudential standards applicable to SLHCs with total
consolidated assets of $50 billion or more and a significant depository
subsidiary, as well as to other SLHCs as determined by the Federal
Reserve.
---------------------------------------------------------------------------
III. Policy Issues
At the outset, it is seemingly inconceivable that Congress, or any
regulator, could conclude that the same capital requirements should
logically or appropriately apply to all financial services companies
that are deemed systemically important. Various types of financial
services companies have different business purposes and asset and
liability structures, and they are exposed to different types of risk.
As explained in the December 11, 2012 Letter from 33 Members of
Congress, ``[s]trong capital standards need to be consistent with the
business models of the industry to which they are applicable''.
Nonetheless, some have read Section 171, in isolation, to require the
Federal Reserve to apply automatically the same capital framework
applicable to banking organizations to all the Covered Insurance
Companies, as well as all other Nonbank SIFIs.
It is important to stress that the policy issue is not about the
need for robust capital requirements for Covered Insurance Companies.
The conclusion that such requirements are essential should be beyond
disagreement. Indeed, the insurers themselves, in comment letters to
the Federal Reserve and other banking agencies, have supported strong
capital requirements for the industry.\8\
---------------------------------------------------------------------------
\8\ See, e.g., Letter to Jennifer J. Johnson from MetLife, Inc.
(April 30, 2012); Letter to Ben S. Bernanke, Martin J. Gruenberg and
Thomas J. Curry from MetLife, Inc. (Oct. 22, 2012); Letter to the
Office of the Comptroller of the Currency, Jennifer J. Johnson and
Robert E. Feldman from Prudential Financial, Inc. (Oct. 22, 2013); and
Letter to Jennifer J. Johnson, Thomas J. Curry and Robert E. Feldman
from State Farm Insurance Companies (Oct. 19, 2012).
---------------------------------------------------------------------------
The real policy question is how best to implement robust capital
requirements for Covered Insurance Companies. Is it preferable to
import the Bank Capital Framework into the regulatory regime for
Covered Insurance Companies or instead to rely principally upon
substantive regulation under State insurance law, including, most
pertinently, the risk-based capital requirements developed pursuant to
the National Association of Insurance Commissioners' Risk-Based Capital
(``RBC'') framework?
The application of the Bank Capital Framework to Covered Insurance
Companies would be inappropriate, redundant and punitive, not only
because it is a second capital regime (in addition to the RBC
framework), but because the Bank Capital Framework was not designed to,
and does not, take into account the critically significant differences
between the business of banking and the business of insurance. This
essential point is reflected in comment letters to the Federal Reserve
by many Members of Congress, including Senator Collins and Members of
the Senate Banking Committee.\9\
---------------------------------------------------------------------------
\9\ See, e.g., Letter to Ben S. Bernanke, Martin J. Gruenberg and
Thomas J. Curry from Senator Susan Collins (Nov. 26, 2012) and the
December 11, 2012 Letter.
---------------------------------------------------------------------------
Let me summarize the fundamental difference between the balance
sheets and business models of banks and insurance companies and why
that difference compels the conclusion that the Bank Capital Framework
is not the appropriate framework to govern insurance company capital.
Banks perform the crucial role in our economy of maturity
transformation, in which deposits and other short-term liabilities are
invested in longer-term loans and other assets. This essential role,
however, creates the potential for a loss of liquidity at banks in the
event of a loss of this short-term funding. Consequently, in addition
to enhanced liquidity requirements, the current regulatory framework
for banks includes a substantially enhanced set of capital requirements
(and related stress tests) that are designed to create a high level of
loss-absorbing capital to help ensure that banks can withstand losses
on assets and resultant strains on liquidity.
In contrast, insurance companies do not engage in maturity
transformation and, generally, have long-term liabilities. Moreover,
historical experience, and the nature, structure and design of
insurance products, indicate that there is no meaningful risk of
``policyholder runs''. Among other factors, even if an insurance policy
can contractually be surrendered, the policyholder may find that a
comparable policy is not readily available (for example, because of
age, health, etc.), and the switch could be time-consuming and will
involve ``breakage'' costs--all in contrast to the ease of switching a
bank deposit. As a result, capital requirements tailored for banks that
are funded, in large part, through short-term liabilities do not
constitute an appropriate framework for the businesses of insurers,
which are liability-driven and have longer-term assets and liabilities.
This fundamental difference between the business models and
liability mixes of banks and insurers, and the consequences for capital
requirements, was thoughtfully articulated by Federal Reserve Governor
Daniel Tarullo in testimony before the Senate Banking Committee:
The problem here, Mr. Chairman, comes I think on the liability
side of the balance sheet. Bank-centered capital requirements
are developed with an eye to the business model of banks and
the challenge that the FDIC would have in resolving a bank, or
now a systemically important banking organization that would be
in deep trouble.
The more or less rapid liquidation of a lot of those claims and
the runs on a lot of the funding of that institution, lie
behind the setting of the capital ratio. But the liability side
of an insurance compan[y's] balance sheet, a true insurance
company [like] somebody selling life insurance for example, is
very different. There's not a way to accelerate the runs of
those, of that funding.\10\
---------------------------------------------------------------------------
\10\ Mitigating Systemic Financial Risk: Hearing Before the S.
Banking, Housing and Urban Affairs Comm., 113th Cong. (July 11, 2013)
(testimony of Daniel K. Tarullo).
Likewise, Federal Reserve Chair Janet Yellen testified before the House
Committee on Financial Services that ``[w]e understand that the risk
profiles of insurance companies really are materially different . .
.''.\11\
---------------------------------------------------------------------------
\11\ Monetary Policy and State of the Economy: Hearing Before the
H. Financial Services Comm., 113th Cong. (Feb. 11, 2014) (testimony of
Janet L. Yellen).
---------------------------------------------------------------------------
It is highly relevant that Congress explicitly recognized that the
evaluation of the risk of assets could not be separated from
consideration of the method by which those assets are funded. Section
165(b)(3)(A) of Dodd-Frank expressly requires the Federal Reserve to
consider differences between Nonbank SIFIs and BHC SIFIs and, in
particular (through incorporation of Section 113(a)), the nature of the
institution's assets and liabilities, including its reliance on short-
term funding. Likewise, former Federal Reserve Chairman Bernanke
testified that ``insurance companies have both a different composition
of assets and a different set of liabilities, and appropriate
regulation needs to take that into account.''\12\
---------------------------------------------------------------------------
\12\ Monetary Policy and the State of the Economy: Hearing Before
the H. Fin. Services Comm., 112th Cong. (July 18, 2012) (testimony of
Ben S. Bernanke).
---------------------------------------------------------------------------
In Appendix A to this testimony, I have described three specific
examples of issues that would arise from trying to force Covered
Insurance Companies into a bank-centric capital regime. These examples
are intended to be illustrative of the fundamental problem I have just
described, but should not be taken to suggest there is a finite list of
issues that if ``fixed'' would eliminate all the negative consequences
that would result from applying the Bank Capital Framework, even on a
``retro-fitted'' basis. These are merely symptomatic of the larger
issue of applying the Bank Capital Framework to insurance companies for
which it was never intended or designed.
The examples do illustrate how the application of the Bank Capital
Framework would require Covered Insurance Companies to hold capital
that is not correlated to the risk profile of their underlying
liabilities and assets. The result would be to impose upon Covered
Insurance Companies lower returns on equity, both in absolute terms and
in relation to their peer firms (both domestic and international), as
well as unnecessary regulatory costs. Because lower returns do not
constitute a viable strategy for Covered Insurance Companies (or their
investors), their only option to retain marketplace vitality would be
to increase the costs for their insurance products and services and
cease offering some products altogether because of the uneconomic
capital charge. Not only is such an approach obviously antithetical to
the best interests of consumers and other customers, but it would also
create a substantial competitive disadvantage for Covered Insurance
Companies. As set forth in the October 17, 2012 Letter from twenty-four
Senators, ``applying a bank-focused regime to insurance companies could
undermine potential supervision and unintentionally harm insurance
policyholders, savers and retirees''.
Let me deal briefly with three arguments made against
differentiation. The first is that we need simplicity in our capital
rules, and, once we start distinguishing among financial institutions,
it will not be possible to stop. Simplicity is a legitimate goal, but
it should not degenerate into simplemindedness if it produces illogic,
inequity and redundancy. And we are not talking about fine
distinctions, but an obvious and palpable dichotomy. As the December
11, 2012 Letter argues persuasively, ``it is not workable to have one
uniform capital standards regulation to apply across the whole spectrum
of financial services companies . . . [I]nsurers have a completely
different business model and capital requirements than banks, which
must be appropriate recognized in the [capital rules applied to Covered
Insurance Companies]''.
The second argument is that an asset should receive the same
capital charge irrespective of the type of financial services company
that holds the asset. Although this argument may have an appealing
simplicity, it results in a divorce of capital from risk because it
fails to take into account both sides of the balance sheet. It fails to
consider either the purpose for which the asset is held or the
institution's ability, due to its liability structure, to hold the
asset in times of stress. As I just discussed, the risk weighting
developed for bank assets was not designed to reflect that purpose or
capability in the context of insurance companies.
Third, some may argue that any concern about the application of the
Bank Capital Framework to Covered Insurance Companies is misplaced
because ``more capital is always better''. That argument can only be
valid, however, if a company's appeal to investors is, contrary to all
evidence, divorced from return on equity and its pricing of a product
is likewise divorced from the capital assigned to it. To the contrary,
capital requirements that are higher because they are not correlated to
risk, produce marketplace and competitive distortions. Such
uncorrelated capital requirements can increase the cost of financial
products and services and even reduce the availability of lower-margin
products and services. Once again, the debate is not about whether we
should have robust capital requirements for all participants in the
financial services industry--2008 should have resolved that debate once
and for all. Instead, the only legitimate debate is whether the same
capital framework should be artificially imposed without regard to the
nature of the financial services company.
IV. The Federal Reserve's Authority To Tailor the Application of
Section 171
As discussed, there has been an extraordinary ``meeting of the
minds'' among Members of Congress, regulators and the insurance
industry that, as a policy matter, the Bank Capital Framework should
not be applied to Covered Insurance Companies. To date, however, the
Federal Reserve has expressed a concern that the language of Section
171 significantly constrains its interpretative ability.\13\
---------------------------------------------------------------------------
\13\ For example, although in recent testimony before the Senate
Banking Committee, Federal Reserve Chair Janet Yellen recognized the
``very significant differences between the business models of insurance
companies and banks,'' she continued that ``the Collins Amendment does
restrict what is possible for the Federal Reserve''. (Semiannual
Monetary Policy Report to the Congress: Hearing Before the S. Banking,
Housing and Urban Affairs Comm., 113th Cong. (Feb. 27, 2013) (testimony
of Janet L. Yellen)).
---------------------------------------------------------------------------
The Federal Reserve may be reluctant to be seen as usurping a
Congressional prerogative and intervening in an area where Congress has
legislated. It is also understandable that an administrative agency
would take the position that, if there is an ambiguity or error in what
Congress has drafted, the agency should not act until Congress has had
the opportunity to resolve the issue. Nonetheless, as I have previously
written in a letter available on the Federal Reserve's Web site, I
believe that there is sufficient flexibility in the statutory language
of Dodd-Frank for the Federal Reserve to determine that Covered
Insurance Companies should not be bound by the same capital regime that
applies to banking organizations.
I will now explain why the Federal Reserve has this interpretative
authority, and can exercise that authority while at the same time
maintaining fidelity to the plain language of Dodd-Frank and to
Congressional intent. The analysis of the issue can be best understood
by dividing it into three parts: the specific language of Section 171;
the broader context of the Dodd-Frank Act as a whole, in particular,
Section 165; and what I believe to be the most direct approach the
Federal Reserve could take to resolve this issue.
A. Section 171 Language
As noted earlier, Section 171 does not prescribe specific capital
requirements, but provides that the capital requirements applied to
companies subject to Section 171 be (i) not ``less than'' the capital
requirements applied to banks now or in the future nor (ii)
``quantitatively lower'' than the bank capital requirements in place as
of the date of the enactment of Dodd-Frank.
What is striking about the language of Section 171 is the absence
of a precise and simple statement that Nonbank SIFIs should be subject
to the Bank Capital Framework. If that were what Congress intended, it
would have been a simple matter for Congress to have said so. Rather,
the language of Section 171 calls for a comparability analysis between
the capital regime imposed by the Federal Reserve on Covered Insurance
Companies and the Bank Capital Framework, and provides only broad
guidance as to how the Federal Reserve is to conduct this analysis.
Because Section 171 is not prescriptive as to how the Federal
Reserve is to conduct the comparability analysis, the Federal Reserve
is authorized to adopt a reasonable interpretation of Section 171 to
fill in these gaps. As the Supreme Court has made clear, in
circumstances where ``the subject matter . . . is technical, complex,
and dynamic . . . as a general rule, agencies have authority to fill
gaps where statutes are silent.''\14\ This fundamental principle of
regulatory authority applies with full force here. It is presumably
beyond debate that Section 171 is ``technical'' and ``complex''. It is
likewise ``dynamic'' because the bank capital rules will continue to
evolve, as will the assessment of ``comparability''. In dealing with
subject matter of this nature, it was not error, but logical, for
Congress to grant significant discretion to the Federal Reserve in
implementing Section 171.
---------------------------------------------------------------------------
\14\ Nat'l Cable & Telecommunications Ass'n, Inc. v. Gulf Power
Co., 534 U.S. 327, 339 (2002).
---------------------------------------------------------------------------
Indeed, in a demonstration of this discretionary latitude, the
Federal Reserve and the other Federal banking agencies have
appropriately exercised this discretion in at least one case. In the
agencies' rules implementing Basel III, the agencies provided that the
assets in separate accounts that are not guaranteed would generally
receive a risk weight of 0 percent.
Accordingly, even reading Section 171 in isolation, the Federal
Reserve has flexibility to apply capital requirements to Covered
Insurance Companies that are appropriately tailored for the business
and risk profile of these institutions.
B. Section 171 in the Broader Context of Subtitle C of Title I of Dodd-
Frank
This conclusion is even more compelling when Section 171 is read in
context with the overall statutory scheme of which it is a part. It is
a fundamental canon of statutory construction, mandated by the Supreme
Court, that individual provisions of a statute must be read in the
context of the overall statutory scheme.\15\ Accordingly, Section 171
must be read as part of the entirety of Subtitle C of Title I of Dodd-
Frank, which establishes a new, comprehensive framework for the Federal
supervision of BHC SIFIs and Nonbank SIFIs in order to address the
risks posed by such institutions to financial stability.
---------------------------------------------------------------------------
\15\ FDA v. Brown & Williamson Tobacco Corp, 529 U.S. 120, 133
(2000) (citations omitted) (``It is a `fundamental canon of statutory
construction that words of a statute must be read in their context and
with a view to their place in the overall statutory scheme.' . . . A
court must therefore interpret the statute `as a symmetrical and
coherent regulatory scheme' . . . and `fit, if possible, all parts into
an harmonious whole . . . ' ''). See also Conroy v. Aniskoff, 507 U.S.
511, 515 (1993) (Looking to the ``text and structure of the [statute]
as a whole'' and following ``the cardinal rule that a statute is to be
read as a whole . . . since the meaning of statutory language, plain or
not, depends on context.'' (internal quotations omitted)).
---------------------------------------------------------------------------
A central tenet of Subtitle C is that there must be both robust
regulation and differentiated regulation. Not only are these two
objectives not inconsistent, but they are mutually reinforcing because
regulation that is directed to the actual risk involved is inherently
more robust than regulation divorced from risk. Therefore, when Section
171 is read in the context of the other provisions of Subtitle C, it
must be interpreted consistently with Congress's intent that the
capital and other requirements for Covered Insurance Companies, and
other Nonbank SIFIs, be applied in a tailored and flexible manner.
The cornerstone of Subtitle C's regulatory framework is the
``enhanced prudential standards'' in Section 165. Section 165 gives the
Federal Reserve broad authority to apply these standards to Nonbank
SIFIs, including Covered Insurance Companies,\16\ in a tailored manner.
Indeed, differentiated application is not merely acceptable but
required.
---------------------------------------------------------------------------
\16\ Section 165 applies, by its terms, only to BHC SIFIs and
Nonbank SIFIs. It does not expressly apply to SLHCs. As a result, one
could argue that, as a technical matter, Section 165 is inapposite to
the application of Section 171 to SLHCs. In its recent rulemaking
implementing the enhanced prudential requirements of Section 165,
however, the Federal Reserve, relying on its general authority under
the Home Owners' Loan Act to regulate SLHCs, indicated that it would
expect to apply enhanced prudential requirements to any SLHC that has
both $50 billion or more in total consolidated assets and a significant
depository subsidiary. The Federal Reserve indicated that it would also
apply enhanced prudential requirements to any other SLHC as the Federal
Reserve considers appropriate. As a result of this Federal Reserve
position, any argument based on the statutory language that Section 165
cannot be read to inform Section 171 with respect to insurance-based
SLHC is not viable.
---------------------------------------------------------------------------
In requiring the Federal Reserve to develop enhanced prudential
standards for Nonbank SIFIs, Section 165 is replete with instructions
that the Federal Reserve apply these standards through a differentiated
approach that takes into account the nature of the institutions and the
risks they present. Section 165(a)(2)(A) is titled ``Tailored
Application'', and it expressly authorizes the Federal Reserve to
``differentiate among companies on an individual basis or by category,
taking into consideration their capital structure, riskiness,
complexity . . . and any other risk-related factors that the [Federal
Reserve] deems appropriate''.
Three other provisions of Section 165 reinforce this
differentiation approach.
First, Subsection 165(b)(3)(A) requires the Federal
Reserve, in applying enhanced prudential standards, to take
into account differences between Nonbank SIFIs and BHC SIFIs,
including the following factors:
whether the institution is already regulated by a primary
financial regulator;
the nature and mix of the institution's activities;
the amount and nature of the institution's liabilities,
including the degree of reliance on short-term funding; and
other appropriate risk-related factors, as determined by
the Federal Reserve.\17\
---------------------------------------------------------------------------
\17\ Section 165(b)(3)(A), as applicable to Covered Insurance
Companies, incorporates Section 113(a), which lists the considerations
FSOC must take into account when determining whether to designate an
institution as a Nonbank SIFI.
Second, Section 165(b)(3)(D) explicitly requires the
Federal Reserve to ``adapt the required standards as
---------------------------------------------------------------------------
appropriate in light of any predominant line of business''.
Third, Section 165(b)(4), as applicable to Covered
Insurance Companies, requires the Federal Reserve to consult
with the insurance commissioner representative on the FSOC
prior to implementing enhanced prudential requirements under
Section 165 to the extent those requirements are likely to have
a significant impact on Covered Insurance Companies.
These multiple provisions of Section 165 make clear that Congress
expected the Federal Reserve to tailor its enhanced prudential
standards to the particular circumstances of insurance companies (and
other Nonbank SIFIs), including with respect to capital requirements.
In addition to Section 165, Section 169, which applies
independently to modify both Section 165 and Section 171, requires the
Federal Reserve to ``take any action'' that it ``deems appropriate'' to
avoid imposing requirements that are duplicative of requirements
already imposed on institutions by other provisions of law. It is
difficult to imagine a clearer instruction, a broader grant of
discretion to a Federal banking regulator or a provision that more
directly applies to the treatment of Covered Insurance Companies under
Section 171. Given that Covered Insurance Companies are already subject
to the comprehensive RBC framework under State insurance law, imposing
the Bank Capital Framework on Covered Insurance Companies would be not
merely duplicative of, but would be at odds with, the State law capital
requirements. Accordingly, even if Section 171 could otherwise be read
to require the application of the Bank Capital Framework to Covered
Insurance Companies (which, as noted, I believe it should not), Section
169 is such a clear and broad grant of authority that it would override
any such requirement and would require the Federal Reserve to take
action to avoid imposing the Bank Capital Framework on Covered
Insurance Companies.
Another fundamental canon of statutory construction that is
directly relevant to this analysis is that different statutory
provisions must be read consistently rather than in conflict.\18\
Indeed, the Federal Reserve and the other banking agencies have
acknowledged that ``the relationship between the requirements of
section 171 and other aspects of [Dodd-Frank], including section 165,
must be considered carefully and . . . all aspects of [Dodd-Frank]
should be implemented so as to avoid imposing conflicting or
inconsistent regulatory capital requirements''.\19\ It is seemingly
incontrovertible that reading Section 171 to preclude differentiation
would conflict with the basic mandate in Section 165 to require
differentiation. Likewise, such a reading of Section 171 would conflict
with the Section 169 requirement to avoid duplication.
---------------------------------------------------------------------------
\18\ See note 15 supra. See also Watt v. Alaska, 451 U.S. 259, 266-
67 (1981) (``[W]e decline to read the statutes as being in
irreconcilable conflict without seeking to ascertain the actual intent
of Congress . . . We must read the statutes to give effect to each if
we can do so while preserving their sense and purpose.'') (citations
omitted).
\19\ 76 Fed. Reg. 37,620, 37,626 (June 28, 2011).
---------------------------------------------------------------------------
Moreover, there is no indication in Section 171 itself, or
elsewhere in Subtitle C, that Section 171 was intended to ``override''
Congress's basic instructions in Sections 165 and 169 for the
development and application of capital and other prudential standards
for Covered Insurance Companies in a tailored, flexible and
nonduplicative manner. Sections 165, 169 and 171 can only be reconciled
if Section 171 is interpreted to require a comparable capital regime as
opposed to an identical capital regime. This approach would fulfill the
objectives of all three provisions, whereas any more prescriptive
reading of Section 171 would undermine the Section 165 requirements of
tailoring and differentiation and the Section 169 restrictions on
duplication. Any more prescriptive reading is also illogical. It would
imply that Section 171 imposed more stringent capital requirements on
Covered Insurance Companies than Section 165, even though Section 165
is the key provision that is supposed to impose enhanced (i.e., more
stringent) capital and other requirements than those generally applied
under Section 171.
There is one other issue of statutory consistency. Both Section
5(c)(3) of the Bank Holding Company Act \20\ and the McCarran-Ferguson
Act of 1945 \21\ codify the long-standing Federal policy that State
laws are to regulate the business of insurance. A reading of Section
171 that overrides this policy would create a conflict that is not
necessary.
---------------------------------------------------------------------------
\20\ 12 U.S.C. 1844(c)(3)(A).
\21\ 12 U.S.C. 1012(b).
---------------------------------------------------------------------------
Thus, upon analyzing Section 171 in context of Subtitle C as a
whole, in particular, Sections 165 and 169, and other statutory
schemes, the Federal Reserve is clearly authorized to apply the
requirements of Section 171 to Covered Insurance Companies in a
tailored, flexible and nonduplicative manner that recognizes and
accounts for the differences between Covered Insurance Companies and
banks.
C. A Solution Consistent with the Plain Language of Section 171 and
Subtitle C
The Federal Reserve may have several options to interpret Section
171 in a way that is both consistent with its terms and maintains
fidelity to Subtitle C as a whole. The solution, however, that I will
now describe may be the most direct and consistent approach. There are
two steps.
First, the Federal Reserve would make a determination that the RBC
framework that already applies to the insurance operations of Covered
Insurance Companies is comparable to the Bank Capital Framework. If,
however, the Federal Reserve were to conclude, after consultation with
insurance regulators, that the existing minimum capital levels required
under the RBC framework are not sufficiently stringent for ``enhanced
prudential standards'', the answer is not to substitute an entirely
different capital framework. Rather, the Federal Reserve can simply
require that Covered Insurance Companies maintain some percentage
greater than 100 percent of the RBC framework's required capital levels
to achieve a level of stringency deemed appropriate to support such
operations.
Second, the Federal Reserve would apply the Bank Capital Framework
on a consolidated basis to the top-tier holding company of a Covered
Insurance Company, but with what is in effect an adjustment for the
insurance operations. Any assets of the top-tier holding company held
in an insurance company that complies with the RBC framework (as it may
be modified by the Federal Reserve) would receive a risk weight of 0
percent and the RBC capital attributable to those insurance company
assets would be deducted from total capital. Under this approach, the
holding company's noninsurance assets and activities (including parent
company only assets), i.e., those not regulated under the RBC
framework, would continue to be subject to the existing Bank Capital
Framework and would require separate and appropriate levels of capital
to support such activities. A similar approach could be applied to the
leverage requirements.
This approach would not only assure robust and differentiated
capital requirements and reconcile the various relevant provisions of
Subtitle C, but also would have several other advantages. First, it
would apply the Bank Capital Framework to the parent company entity on
a consolidated basis, which conforms with Section 171. This result also
addresses directly the concern that Senator Collins and former FDIC
Chairman Bair identified as an impetus for Section 171--that, in the
financial crisis, holding companies were a source of weakness, rather
than strength, to their operating subsidiaries.\22\ Second, it would be
grounded in the Federal Reserve's existing authority, which the Federal
Reserve has exercised previously,\23\ to modify risk weights in the
existing Bank Capital Framework in order to tailor those requirements
for insurance company assets. Third, it would satisfy the not ``less
than'' and not ``quantitatively lower than'' requirements in Section
171 by leaving in place the numerical ratios underlying the Bank
Capital Framework (that is, the numerical ratio requirements under
Basel I and Basel III). Fourth, it would build on the existing RBC
framework tailored to Covered Insurance Companies, and thereby satisfy
the mandate in Section 169 for the Federal Reserve to take action to
avoid imposing duplicative requirements on Covered Insurance Companies.
---------------------------------------------------------------------------
\22\ 156 Cong. Rec. S3459, 3460 (daily ed. May 10, 2010).
\23\ As the Federal banking agencies have recognized, Congress did
not forbid the agencies from modifying, over time or in response to
changes in circumstances, the calculation of the components of the
numerical ratios in the bank capital requirements. See 77 Fed. Reg.
52,888, 52,892 (Aug. 30, 2012).
---------------------------------------------------------------------------
This suggested approach would also give effect to Congressional
intent, as evidenced both in the comments of Senator Collins and in the
December 11, 2012 Letter in which thirty-three Members of Congress
asked the Federal banking agencies to ensure that the capital
requirements for Covered Insurance Companies ``consistently reflect
congressional intent by incorporating the State risk-based capital
system and applying capital standards that accommodate the existing
framework for companies engaged in the business of insurance''.
Finally, this approach could be implemented by relying solely on
the flexibility inherent in the language of Section 171. That is, by
applying the numerical ratios in the Bank Capital Framework, the
Federal Reserve would be quite literally imposing capital requirements
that are not ``less than'' nor ``quantitatively lower than'' the bank
capital requirements referred to in Section 171. This approach becomes
even more compelling when considered in the context of the broader
statutory scheme in Subtitle C, where tailoring and avoiding
duplication are the repeated and unambiguous instructions from
Congress.
V. Congressional Action
Even though, as just discussed, I believe the Federal Reserve has
the authority to resolve this issue, and there are solutions available
to the Federal Reserve in the exercise of that authority, there is
obviously a distinction between having the authority to take an action
and having a statutory requirement to do so. Moreover, in the Federal
Reserve's recent promulgation of its rules under Section 165, it
postponed a decision on the capital requirements applicable to Covered
Insurance Companies to further study the issue. I hope that during this
additional period of study, and in view of the firm Congressional
support for resolution of the issue, the Federal Reserve will move
expeditiously to find an interpretative solution to the problem,
whether in the way I have suggested or in some other way.
If, however, the Federal Reserve is not prepared to act promptly, I
would strongly urge Congress to act to prevent a result that is so
clearly unwarranted and potentially so damaging. The legislation
previously proposed by Senators Brown and Johanns, and today by Senator
Collins, represents a sound basis for moving forward. In asking for
Congress to act in this matter, I realize that it may seem a ``heavy
lift'', not because of the substance, but because of a reluctance to
permit any amendment to the Dodd-Frank Act. The concern is apparently
that any amendment would open the door to further amendments that are
much more controversial and divisive.
But certainly Dodd-Frank is not such a perfect piece of legislation
that any and all amendments should be resisted for all time. When the
absence of an amendment would result in perpetuating an adverse result
that Congress has clearly stated, on a bipartisan basis, it did not
intend, Congress should not be irrevocably barred. Indeed, Congress
would be departing from its own fundamental principles if it sought to
bind future Congresses from absolutely any reconsideration of what was
legislated by its predecessors.
I do recognize the concern about ``opening up'' Dodd-Frank when
there has not been sufficient time to evaluate its impact. But, if
there were ever to be any change, this is the time and place to do so.
An amendment to clarify Section 171 would be both surgical and
noncontroversial; of most importance, it is the right result.
VI. Conclusion
In summary, given the virtually unanimous support for finding a
solution to the policy issue raised by Section 171, and the flexibility
the Federal Reserve has under the terms of Section 171 and Subtitle C,
the Federal Reserve can, and should, act to avoid the negative
consequences of applying the Bank Capital Framework to Covered
Insurance Companies. In the absence of prompt Federal Reserve action, I
urge Congress to act.
Appendix A
1. Policy Loans:
As a service to its customers, an insurance company may loan a life
insurance policyholder up to the existing cash surrender value of his
or her policy, secured by the cash surrender value of the policy. The
cash surrender value of the policy is a liability on the insurance
company's balance sheet. In this way, the loan is fully collateralized,
but unlike a collateralized bank loan, the insurance company is not
subject to the risk that the collateral will not cover its exposure
under the loan. If the policyholder defaults, the insurance company
will reduce the benefits it pays to the policyholder, which will result
in the insurer reducing the liability it records for the policy. An
insurance company can always recoup a $100 policy loan default by
reducing its liability to the customer under the policy by $100.
Despite the fact that the policy loan never exposes the insurance
company to credit or market risk, under the Bank Capital Framework--
with the mindset of a traditional collateralized bank loan--would
require an insurance company to hold Tier 1 capital against the loan at
a risk weight of 20 percent.
2. Guaranteed Separate Accounts:
Many insurance companies offer an insurance product that allows a
customer to place funds with an insurance company to be invested and
managed by the insurance company, separately from its general assets,
with the goal of providing the customer with the income stream from the
investments, often upon retirement. These so-called ``separate
accounts'' may be in guaranteed or nonguaranteed form and have varying
features and conditions. The basic concept is that, with a guaranteed
account, the insurance company guarantees the customer a fixed income
stream, with the insurance company exposed if the value of assets in
the account drops below a guaranteed amount at the end of the
investment period. Annuities are frequently in the form of a guaranteed
separate account.
In the banking context, a guarantee is viewed as a contingent
liability that may become fully due at any time. In the insurance
context, the separate account products such as annuities are typically
structured in such a way that the full liability is not all due at
once; the period over which the guaranty payment is made is both long
(often 15-20 years) and requires a long waiting period (often 10 years)
before any payment is made. This contractual protection substantially
eliminates the liquidity concern that the insurance company would need
to draw on its own assets to make up for the full amount of the
shortfall all at once.
The Bank Capital Framework includes no tailoring for insurance
company guaranteed accounts with these protective features. Moreover,
because U.S. generally accepted accounting principles require a
provision to be made on the insurance company's books to reflect the
amount of the insurance company's exposure for the guarantee, requiring
additional capital be held against not just the exposure but the entire
account results in double-counting.
3. Corporate Bonds:
The Bank Capital Framework is, in a number of respects, tailored
for the types of assets held by banks in relatively large amounts. For
example, there are different, tailored risk weights for mortgage loans
(based on the quality of the loan), sovereign debt (based on categories
for various countries), exposures to other U.S. depository institutions
and credit unions and exposures to U.S. public sector obligations
(based on whether the obligation is general or revenue).
Insurance companies generally hold a significant portion of their
assets in corporate bonds--and a greater portion than do banks because
bond maturities better fit the insurance company's asset-liability
matching and investment needs. Yet, the Bank Capital Framework is not
tailored for corporate debt, so, unlike the RBC framework, there is no
distinction between higher and lower quality bonds (as there is for
mortgage loans and sovereign debt under both the Bank Capital Framework
and the RBC framework), subjecting all corporate bonds to a 100 percent
risk weight. This relatively crude approach is understandable when
corporate bonds represent only a small portion of the assets that banks
hold, but not when they represent a much larger portion at insurance
companies. This exemplifies how the Bank Capital Framework simply was
not designed to be applied to insurance companies.
______
PREPARED STATEMENT OF AARON KLEIN
Director, Financial Regulatory Reform Initiative
Bipartisan Policy Center
March 11, 2014
Chairman Brown, Ranking Member Toomey, Members of the Subcommittee,
thank you very much for the opportunity to testify at this hearing of
the Subcommittee on Financial Institutions and Consumer Protection. I
have tremendous respect for the critical role this Committee plays in
shaping the financial regulatory and economic policies that have an
enormous effect on the lives of all Americans. I am especially honored
to appear before you, having served for over 8 years on the
professional staff of the Committee on Banking, Housing, and Urban
Affairs, mostly as Chief Economist for former Chairmen Sarbanes and
Dodd.
Bipartisan Policy Center Financial Regulatory Reform Initiative (FRRI)
I serve as the Director of the Financial Regulatory Reform
Initiative at the Bipartisan Policy Center. Founded in 2007 by former
Senate Majority Leaders Howard Baker, Tom Daschle, Bob Dole, and George
Mitchell, BPC is a Washington-based think tank that actively seeks
bipartisan solutions to some of the most complex policy issues facing
our country. In addition to financial regulatory reform, BPC has
ongoing projects in housing, immigration, and the Federal budget. The
Financial Regulatory Reform Initiative's overarching objective is to
promote policies that balance financial stability, economic growth, and
consumer protection. Finding the right capital regulations for
insurance companies under the Dodd-Frank Act is a critically important
issue. I commend you for focusing the Committee's attention on the
issue. My testimony will focus on the following four key points:
1. The business of insurance is fundamentally different from that of
banking and hence must be subject to appropriate yet different
capital standards.
2. Regulators need to overcome their ``bank-centric'' approach when
regulating insurance companies.
3. The Dodd-Frank Act envisions regulators overcoming bank-
centricity and empowers them to do so.
4. A more optimal regulatory approach should include a Federal
insurance regulator and optional Federal charter. The benefits
of such a regulator grow if the Federal Reserve is unable to
adjust its bank-centric approach to insurance companies.
Insurance and Banking are Fundamentally Different Businesses, With
Different Balance Sheets, Business Models, and Risk Profiles
To understand why it is so important that insurance companies be
subject to insurance-based capital regimes, not bank-based capital
regimes, one must first appreciate the fundamental differences in their
business models, balance sheets, and risk profiles.
The Business of Insurance
At its core the business of insurance is about aggregating risks
and matching assets to liabilities. Insurance companies are in the
business of taking on risk of different tenures and matching assets and
reserves against this risk. The precise approach varies tremendously by
the type of insurance product. A company that provides auto insurance,
usually on a 6- or 12-month basis, has to have a different asset and
liquidity structure than a company that provides life insurance, which
is often issued on a multi-decade contract.
Aggregating risk avoids adverse selection by offering highly
competitive products that attract broad market share and a large pool
of customers to minimize risks. Insurance companies that are able to
capture more of a given market are able to more accurately protect
themselves against adverse selection and statistically unlikely
outcomes. By accumulating and pooling risk, insurance companies allow
people to transfer the financial risk of getting into a car accident,
losing a loved one, or outliving their assets to a broad risk pool.
Aggregating appropriate risk thus paradoxically makes insurance
companies safer.
The Business of Banking
Unlike insurance companies, which agglomerate and manage risk,
banks are in the business of mitigating risk. Over-concentration in a
specific business line is a classic ``red flag'' for regulators of
safety and soundness problems. A key purpose of banks is to transfer
timing risk; banks allow depositors to instantly access their funds,
while using deposits to make longer-term loans to consumers and
businesses. This process is often referred to as maturity
transformation. As the Bipartisan Policy Center's Failure Resolution
Task Force found, ``maturity transformation is the socially beneficial
process by which financial institutions fund themselves with short-term
borrowings and use these funds to make longer-term loans or investments
in other illiquid assets. Without maturity transformation, our modern
economy would grind to a halt.''\1\
---------------------------------------------------------------------------
\1\ John F. Bovenzi, Randall D. Guynn, and Thomas H. Jackson, ``Too
Big to Fail: The Path to a Solution,'' Bipartisan Policy Center, May
2013, p. 17. Available at: http://bipartisanpolicy.org/sites/default/
files/TooBigToFail.pdf.
---------------------------------------------------------------------------
Can Banking and Insurance Coexist?
Some economists and policymakers have argued that there are
economies of scale in mixing the provision of banking and insurance
services. This theory was prominent in the 1990s and was one of the
driving forces behind the Gramm-Leach-Bliley Act, which repealed the
prohibition on the mixing of banking and insurance. The theory was
tested more than 15 years ago on a large scale with the merger of
Citicorp and Travelers Group. Many commentators at the time expected
more mergers and the creation of ``financial supermarkets'' to provide
both services. At the time, Travelers CEO Sanford Weill said that the
merger would create ``a model of the financial services company of the
future,'' a sentiment shared by others in the industry.\2\
---------------------------------------------------------------------------
\2\ Yvette D. Kantrow and Liz Moyer, ``Citi, Travelers: A Global
Leader Takes Shape,'' American Banker, April 7, 1998. Available at:
http://www.americanbanker.com/175/citi-travelers-a-global-leader-takes-
shape-1041890-1.html.
---------------------------------------------------------------------------
As an empirical economist, I check to see how well reality has
matched theory. In the case of the proposed value of combining banking
and insurance businesses, the expected benefits have not materialized.
With one important exception, which I will discuss in a moment, there
are no examples in the United States of mixing banking and insurance on
any significant commercial scale, although there are examples of
successful acquisitions of smaller banks and thrifts. The Citi-
Travelers merger has been unwound and, in the absence of other similar
mergers, it seems as if these businesses do not mix, even without
regulatory barriers.
A model exception has been the successful provision of banking and
insurance services by USAA. What is interesting about USAA is that it
operates its business on a field-of-membership basis, more analogous to
a credit union than to a bank. Technically, USAA has a thrift regulated
by the Office of the Comptroller of the Currency (OCC) and a thrift
holding company regulated by the Federal Reserve. The membership
requirement involves family military service. The reputation of the
company providing both services is also extremely high,\3\ although I
would not know firsthand, as I am not eligible for its insurance or for
its bank lending activity.
---------------------------------------------------------------------------
\3\ See Tempkin Group, Net Promoter Score Benchmark Study, 2012,
October 2012. Available at http://www.temkingroup.com/research-reports/
net-promoter-score-benchmark-study-2012/. See also David Rohde, ``In
the Era of Greed, Meet America's Good Bank: USAA,'' The Atlantic,
January 27, 2012. Available at http://www.theatlantic.com/business/
archive/2012/01/in-the-era-of-greed-meet-americas-good-bank-usaa/
252161/.
---------------------------------------------------------------------------
Can Regulators Overcome Bank-Centricity To Properly Regulate Insurance
Companies?
Dodd-Frank Empowers the Federal Reserve To Provide Capital Regulation
for Insurers
Dodd-Frank decided to treat thrifts and thrift holding companies
nearly the same way it treats banks and bank holding companies, moving
their supervision to the OCC for thrifts and the Federal Reserve at the
holding company level.\4\ Whether the continued bifurcation of
regulation between holding company and insured depository is a wise
decision is beyond the scope of this hearing, but is something that the
Bipartisan Policy Center's Regulatory Architecture Task Force is
examining and will discuss in a report to be released this spring.
---------------------------------------------------------------------------
\4\ 12 U.S.C. 5412 (b)(2)(B) and 12 U.S.C. 5412 (b)(1)(A).
---------------------------------------------------------------------------
The Federal Reserve is the regulator for a diverse set of insurance
companies under Dodd-Frank. It is unclear how broadly appreciated that
was during consideration of all of the aspects of Dodd-Frank, including
the adoption of the Collins Amendment. What is clear is that Dodd-
Frank's decision to move the regulatory responsibility for thrift
holding companies and nonbank SIFIs to the Federal Reserve was given
along with the ability and responsibility for the Federal Reserve to
recognize differences between these entities and develop appropriate
capital structures, tailored to each entity or separate class of
institutions. The broad authority to tailor was codified in Title I,
Subtitle C of the Dodd-Frank Act.\5\
---------------------------------------------------------------------------
\5\ 12 U.S.C. 5365(a)(2)(A).
---------------------------------------------------------------------------
The Importance of Tailoring Capital Standards for Insurance
The economic rationale for capital regulation and for tailoring is
clear but bears repeating. Capital regulation is necessary for many
purposes, including, to ensure the safety and soundness of financial
institutions so that customers can use these products efficiently and
effectively. There are two main approaches to quantifying capital
regulation for any financial institution. The first is a nonrisk-
sensitive approach, the leverage ratio, which creates a ceiling on
total risk-taking. However, using the leverage ratio alone can have the
perverse effect of encouraging institutions to take on more risk by
treating all liabilities as equally risky and requiring the same amount
of capital. Thus, a risk-based method of capital regulation is required
to quantify risk levels for various assets and liabilities and require
appropriate capital.
The financial crisis demonstrated the problems inherent with over-
reliance on risk modeling. The mispricing of risk is one of the
hallmarks of financial crises. Institutions, regulators, markets, and
models are all susceptible to this mistake. I cannot predict in which
area we will misprice and incorrectly evaluate risk in the future, but
I am certain that it will happen again.
The fundamental question is now how to develop appropriate metrics
for both leverage and risk-based capital as it applies to insurance
companies. Insurance companies differ fundamentally from banks in how
one measures risk and leverage; thus a different capital system,
specifically tailored for insurance companies, is necessary. A
Bloomberg Government report studying this question concluded that:
``the risks that insurers face are different from banks, and that
regulating insurers as if they are banks may be inappropriate and
unfair to insurance companies.''\6\
---------------------------------------------------------------------------
\6\ Christopher Payne, ``Basel Capital Rules May Hinder U.S.
Insurers,'' Bloomberg Brief: Financial Regulation, April 26, 2013.
Available at: http://www.bloombergbriefs.com/files/
Financial_Regulation_042613_p1.pdf.
---------------------------------------------------------------------------
Did Regulators Draw the Right Lessons from the Crisis for Insurers?
An example of the difference in regulatory mindset necessary for
insurance companies can be seen by the treatment of separate accounts.
Regulators made a key mistake in the run-up to the financial crisis by
allowing banks to keep structured investment vehicles (SIVs) off their
balance sheets, exempting SIVs from capital reserve requirements. The
SIVs were ``canaries in the coal mine'' before the last financial
crisis. Assets that were supposed to be low risk were in fact risky and
required banks to raise significant capital during stressed periods--
just at the moment that capital was especially costly. Post financial
crisis, regulators have altered their approach, allowing fewer SIVs to
be classified as ``off balance sheet.'' For this, regulators should be
commended.
Regulators, particularly the Federal Reserve, have also seen their
post-crisis power broadly expanded. The Federal Reserve Board now has
supervisory authority over many insurance companies as well as all
SIFIs. As the Board's authority expands, it is encountering new
products that banks don't offer and are accounted for differently, such
as separate accounts. As defined by the Office of Financial Research
(OFR), separate accounts are those ``in which an asset manager selects
assets on behalf of large institutional investors or high net-worth
individuals under mandates defined in an investment management
agreement. Clients retain direct and sole ownership of assets under
management.''\7\
---------------------------------------------------------------------------
\7\ Office of Financial Research, ``Asset Management and Financial
Stability,'' September 2013. Available at: http://www.treasury.gov/
initiatives/ofr/research/Documents/OFR_AMFS_
FINAL.pdf.
---------------------------------------------------------------------------
Insurance companies use these separate accounts for products such
as variable annuities. The question is whether these accounts are
treated as ``on'' or ``off'' balance sheet for regulatory purposes. To
answer this, regulators must consider the risks separate accounts carry
for insurance companies. Historically, insurance has been regulated by
the States, which have recognized that funds in separate accounts are
more analogous to stock market accounts. Stock brokers are not required
to hold capital against their clients' accounts since the assets in
those accounts do not belong to the broker. Banks, on the other hand,
must retain capital against deposits, since the deposits are
liabilities for banks, and are subject to runs.
A question remains as to whether Federal regulators such as OFR,
the Federal Reserve, and the Financial Stability Oversight Council
(FSOC) will draw the appropriate line with respect to separate
accounts. If the regulators discover that a nonbank is putting its own
solvency at risk and not accounting for separate accounts properly that
would merit new regulatory treatment. So far, data from OFR and from
the States' historical experience regulating insurance companies does
not support that conclusion. Instead, it raises concerns that bank
regulators are misapplying bank-centric lessons into a nonbank world
without a clear understanding of the different risks, balance sheets,
revenue streams, and business models.
The Right Way to Think About Capital Standards
Good regulatory structures involve both minimum capital
requirements through leverage limits and more sophisticated risk-based
capital structures. Both need to be targeted and tailored to the
business that they are regulating. As we have seen, insurance and
banking are fundamentally different businesses with different risk
profiles. Therefore, they require different capital regulatory and
supervisory structures. The Dodd-Frank Act anticipated this and
provided the Board with the necessary flexibility to tailor prudential
standards accordingly to different businesses.
There is broad agreement that tailoring is the right approach.
Federal Reserve Board Chair Janet Yellen said it best: ``[T]here are
very significant differences between the business models of insurance
companies and the banks that we supervise and we are taking the time
that is necessary to understand those differences and to attempt to
craft a set of capital and liquidity requirements that will be
appropriate to the business models of insurance companies.''\8\ The
question is whether the Board will follow through on Chair Yellen's
wise words with carefully considered, differentiated capital standards
for insurers that recognize they are not banks.
---------------------------------------------------------------------------
\8\ Victoria Craig, ``Janet Yellen Talks Disappointing Data,
Weather on Capitol Hill,'' Fox Business, February 27, 2014. Available
at: http://www.foxbusiness.com/economy-policy/2014/02/27/janet-yellen-
talks-dissapointing-data-weather-on-captiol-hill/.
---------------------------------------------------------------------------
Dodd-Frank Envisions and Empowers Regulators To Overcome Bank-
Centricity
Dodd-Frank made clear in several of its provisions the importance
and need for Federal regulators to develop and implement nonbank
capital regimes for regulated nonbank entities, and the ability for
them to do so. These provisions can be found, for example, in sections
112, 120, 165, and 616.\9\ These themes were reiterated to regulators
by Chairman Johnson (D-SD) and Ranking Member Crapo (R-ID) in their
letter to regulators last year: ``In setting the new capital rules for
the United States institutions, your agencies face a formidable task to
carefully tailor the new rules to the unique risks of institutions
while neither hampering lending nor undermining the strength of our
financial system.''\10\
---------------------------------------------------------------------------
\9\ 12 U.S.C. 112 (a)(2)(I); 12 U.S.C. 120 (b)(2)(B); 12 U.S.C.
165 (b)(1)(A)(i); 12 U.S.C. 165 (b)(1)(B)(i); 12 U.S.C. 165
(c)(1); 12 U.S.C. 616 (d)(b).
\10\ U.S. Committee on Banking, Housing, and Urban Affairs,
``Johnson and Crapo Urge Regulators to Address Concerns on Basel III,''
February 13, 2013. Available at: http://www.banking.senate.gov/public/
index.cfm?FuseAction=Newsroom.PressReleases&ContentRecord
_id=f321c69d-e901-e0ee-14eb-2ae6b730ee91&IsPrint=1.
---------------------------------------------------------------------------
I am not an attorney and will not venture an opinion on how the
Federal Reserve should interpret these provisions as they relate to
section 171, often referred to as the Collins Amendment. I will point
out however, that there is broad support, with which I concur, that
capital standards should be tailored for different business models with
different risk profiles. This was the clear intention of Dodd-Frank.
Even if individual bank regulators are unable or unwilling to use a
tailored approach, the FSOC could solve this problem without additional
legislation. Among the duties imposed upon the FSOC in section 112 is
the duty to make recommendations to: (1) member agencies on general
supervisory priorities and principals that reflect the outcome of
discussions among the member agencies; (2) the Board concerning the
establishment of heightened prudential standards, including capital
standards, for nonbank financial companies supervised by the Board; and
(3) primary financial regulators to apply new or heightened standards
and safeguards for financial activities or practices that could create
or increase risks of significant liquidity, credit, or other problems
spreading among bank holding companies, nonbank financial companies,
and U.S. financial markets.\11\
---------------------------------------------------------------------------
\11\ 12 U.S.C. 5322 (a) (2).
---------------------------------------------------------------------------
If these two preferred approaches are not implemented--the
following of the intention of Congress by the Federal Reserve, or the
use of FSOC's authority to make recommendations that the Fed could then
adopt--I would then support a legislative solution to this problem such
as the one proposed by Senators Brown and Johanns in S. 1369.
The Case for Federal Insurance Regulation in a Post-Dodd-Frank World
BPC's Regulatory Architecture Task Force has been examining the
entire financial regulatory structure, as it exists in a post Dodd-
Frank world. The task force's report will be released next month and
will contain many recommendations for how we can improve our current
regulatory structure. One of those recommendations will be to create a
Federal insurance regulator and an optional Federal charter. This
recommendation follows previous bipartisan calls for a Federal
insurance regulator, including legislation introduced by now Chairman
Tim Johnson (D-SD) and then Senator John Sununu (R-NH),\12\ as well as
the comprehensive regulatory restructuring plan issued by the Treasury
Department under Secretary Henry ``Hank'' Paulson, Jr.\13\ It is also
consistent with the framework proposed by Secretary Timothy Geithner in
the 2009 Treasury White Paper, ``Financial Regulatory Reform, A New
Foundation: Rebuilding Financial Supervision and Regulation.''\14\
---------------------------------------------------------------------------
\12\ The National Insurance Act of 2007, S. 49, 110th Congress,
2007.
\13\ The Department of the Treasury, ``Blueprint for a Modernized
Financial Regulatory Structure.'' March 2008. Available at: http://
www.treasury.gov/press-center/press-releases/Documents/Blueprint.pdf.
\14\ The Department of the Treasury, ``Financial Regulatory Reform,
A New Foundation: Rebuilding Financial Supervision and Regulation,''
June 17, 2009. Available at: http://www.treasury.gov/initiatives/
Documents/FinalReport_web.pdf.
---------------------------------------------------------------------------
Dodd-Frank did not follow those calls, but did create a new Federal
Insurance Office (FIO) within the Treasury Department in order to build
Federal expertise in insurance. The FSOC was given the authority to
designate any insurance company as a SIFI and hence transfer regulatory
authority to the FRB. An independent voting member was also created for
the FSOC with the requirement that s/he have insurance expertise.
How has this worked so far? We have limited data as Dodd-Frank is
not yet 4-years old, but the data we do have indicates disagreement and
a lack of consistency. The only public disagreement so far in the
designation process among FSOC members was in the designation of
Prudential, Inc. Roy Woodall, the independent commissioner with
insurance expertise, dissented on the vote to designate Prudential and
was joined by the acting FHFA director. In his dissent, Commissioner
Woodall said that the FSOC's analysis underlying the decision to
designate Prudential was, ``antithetical to a fundamental and seasoned
understanding of the business of insurance, the insurance regulatory
environment, and the State insurance resolution and guaranty fund
systems,'' and that the designation, ``will ultimately lead to the
imposition of requirements that are by all indications ill-suited for
insurance companies.''\15\
---------------------------------------------------------------------------
\15\ S. Roy Woodall, Jr., dissent to the FSOC's designation of
Prudential, Inc. delivered to Council members, September 19, 2013, pp.
1, 7-8. Available at: http://www.treasury.gov/initiatives/fsoc/council-
meetings/Documents/September%2019%202013%20Notational%20Vote.pdf.
---------------------------------------------------------------------------
The upcoming report from BPC's Systemic Risk Task Force will
analyze the FSOC process, focusing particularly on questions regarding
the FSOC's authority and its desire to regulate entities and
institutions as compared to the regulation of activities. As long as
designation of entities remains the main tool at the FSOC's disposal,
it would be reasonable to expect a continued focus on designation. To a
person with a hammer in his hand, problems tend to look like nails.
Has Dodd-Frank Created a Unified Voice for the United States on an
International Basis?
One of the major goals in creating the FIO was to establish a
unified Federal voice on insurance for international regulatory
purposes. Dodd-Frank gave the FIO the authority ``to coordinate Federal
efforts and develop Federal policy on prudential aspects of
international insurance matters, including representing the United
States, as appropriate, in the International Association of Insurance
Supervisors [IAIS].''\16\ The Treasury Department echoes this, stating
that a goal of the FIO is ``to represent the United States on
prudential aspects of international insurance matters, including at the
International Association of Insurance Supervisors.''\17\ However, the
Federal Reserve, citing its newly acquired regulatory responsibilities
over many insurance companies, recently applied for a seat on the IAIS.
The Board's decision to request a seat is understandable given its
desire to acquire additional knowledge and expertise on insurance.
However, it also sends an unclear signal to the international community
as to who speaks for the United States between the chair of the Federal
Reserve Board, the director of FIO, or the NAIC, which represents State
insurance commissioners, the functional regulators for insurance
companies today. The Federal Reserve should publicly affirm that the
FIO is the lead representative for the United States on the IAIS. This
remains an example of the effect of the duplicative and unclear
delegation of authority over regulation of insurance companies.
---------------------------------------------------------------------------
\16\ 12 U.S.C. 313 (c)(1)(E).
\17\ U.S. Department of the Treasury, ``About: Domestic Finance--
Federal Insurance Office.'' Available at: http://www.treasury.gov/
about/organizational-structure/offices/Pages/Federal-Insurance.aspx.
---------------------------------------------------------------------------
Conclusion
BPC's Financial Regulatory Reform Initiative has found that Dodd-
Frank empowered financial regulators with substantial authority and
flexibility to use their tools to improve regulation and achieve better
regulatory outcomes for both financial services providers and end users
of those financial services. We have seen multiple examples of
regulators doing just that, ranging from the Federal Deposit Insurance
Corporation's Single Point of Entry approach to the Consumer Financial
Protection Bureau's use of an open and transparent rulemaking process.
We have also found multiple instances where regulators could have taken
a better approach, such as the Volcker Rule. And, we have found several
instances where additional statutory changes are required, including
the need to add a chapter to the Bankruptcy Code to complement Title II
of Dodd-Frank, and the desirability of an independent inspector general
for the CFPB. However, our work has shown that regulators have
significant tools at their disposal to get things right.
It is clear that banks and insurance companies are fundamentally
different businesses, which require substantially different capital
regimes. In my opinion, Dodd-Frank gave the Federal Reserve Board the
necessary authority to the tailor its capital rules for insurance
companies. The law clearly supports a tailored approach for insurance
companies as well as all nonbank SIFIs. Dodd-Frank envisions a less
bank-centric regulatory approach to the nonbanks the Board regulates
after FSOC designation. It also empowers the FSOC as it relates to
authorities as well as institutions. And, it empowers the Federal
Reserve and FSOC as it relates to capital rules for nonbanks such as
insurers.
If the Federal Reserve Board is unwilling, or unable, to implement
the tailoring regime required in Dodd-Frank to insurance companies, I
would support a legislative solution such as S. 1369 as introduced by
Senators Brown and Johanns. This would be a prominent example of the
inability of regulators to adhere in practice to the construct created
in Dodd-Frank. Whether this signals an isolated instance or a larger
problem remains to be seen. It would add credence to the already strong
argument in favor of some form of dedicated Federal insurance
regulation that recognizes and understands the uniqueness of the
insurance industry and its importance to our economy.
______
PREPARED STATEMENT OF MICHAEL W. MAHAFFEY
Chief Risk Officer, Nationwide Mutual Insurance Company
March 11, 2014
Chairman Brown, Ranking Member Toomey, and Members of the
Subcommittee, thank you for the opportunity to appear before you to
discuss the critical issue of the appropriate capital framework for
insurers supervised by the Federal Reserve. My name is Michael Mahaffey
and I am the Chief Risk Officer for Nationwide Mutual Insurance Company
(Nationwide). I am testifying on behalf of Nationwide but will also
represent the perspective of a diverse group of insurers that fall
under Federal Reserve supervision. Those insurers include both
insurance savings and loan holding companies (SLHCs) and insurance
companies that have been or may be designated by the Financial
Stability Oversight Council (FSOC) as systemically important financial
institutions (SIFIs).
As Nationwide's Chief Risk Officer, I am responsible for overseeing
the company's approach to managing its risk profile, including the key
functions of Stress Testing and Enterprise Risk and Capital Modeling,
Measurement and Management. A critical part of my role is to ensure
that Nationwide meets its internal and external capital requirements so
the company is always well positioned to honor its promises to our
policyholders. In my capacity as Nationwide's Chief Risk Officer, I
believe I can offer a helpful perspective on appropriate capital
regimes for insurers and the consequences of imposing bank-centric
capital rules on companies like Nationwide.
About Nationwide
Nationwide is a Fortune 100 mutual insurance company based in
Columbus, Ohio. For almost 100 years Nationwide has been helping our
policyholder members protect what is most important to them through our
property and casualty and life insurance businesses.
Roughly half of Nationwide's revenue is derived from our property
and casualty businesses, and half is derived from our life insurance
and related businesses. As a result, Nationwide is representative of
both the property and casualty and the life insurance industries.
Nationwide Mutual and its property and casualty insurance subsidiaries
primarily provide personal auto, homeowners, and commercial insurance
products to households and businesses all across the country. In
addition, Nationwide Life Insurance Company, a subsidiary of Nationwide
Mutual, primarily provides life insurance, individual annuities, and
private and public-sector retirement plans. Nationwide also provides
banking products and services through Nationwide Bank, a Federal
savings bank insured by the FDIC.
As of December 31, 2013, Nationwide had approximately $183 billion
in combined assets, while Nationwide Bank had approximately $6 billion
in assets. While Nationwide Bank is critical to our customers and our
business strategy, it is important to note that it represents less than
3 percent of the total assets of the combined organization.
Notwithstanding the bank's de minimis relative size, by virtue of
its ownership of Nationwide Bank, Nationwide is registered as an SLHC.
As an SLHC, Nationwide is now subject to Federal Reserve supervision
and regulation pursuant to the Dodd-Frank Act, including new prudential
requirements designed to enhance the safety and soundness of banking
organizations. These include the Collins Amendment's consolidated
capital requirements, capital stress-testing requirements, and the
Volcker Rule.
The Applicability of the Collins Amendment to Insurers
Pursuant to the Dodd-Frank Act, two categories of insurance
companies came under Federal Reserve supervision--insurers that own
depository institutions (and are thus SLHCs) and insurers that are
designated by the FSOC as nonbank SIFIs. The Dodd-Frank Act conferred
authority on the Federal Reserve to establish group capital
requirements for both categories of companies. Section 616 of Dodd-
Frank granted the Federal Reserve the authority under the Home Owners'
Loan Act (HOLA) to establish group capital requirements for insurance
SLHCs. Likewise, Section 165 of the Dodd-Frank Act provided the Federal
Reserve authority to establish group capital requirements for insurance
SIFIs.
Insurance SLHCs and insurance SIFIs are also subject to the minimum
group capital requirements as set forth in the Collins Amendment. The
Collins Amendment establishes a ``generally applicable'' minimum
capital floor that is no lower than that which was in effect for banks
at the time Dodd-Frank was enacted.
As an SLHC, Nationwide is subject to the Collins Amendment. In
addition, our depository institution, Nationwide Bank, is also
independently subject to the minimum capital standards in the Collins
Amendment. We support the application of the Basel banking capital
standards to Nationwide Bank and we are not seeking to exempt
Nationwide Bank from the Collins Amendment or in any way alter the
capital requirements as applied to Nationwide Bank.
Furthermore, we do not oppose utilization of a group-wide capital
framework for insurance SLHCs and insurance SIFIs. Capital strength is
core to our business proposition--providing our policyholders with
financial protection when they need it the most.
However, it is critically important that any capital framework
established by the Federal Reserve for insurance SIFIs and insurance
SLHCs utilize the appropriate tools. These institutions are
predominantly insurance organizations and it would be inappropriate to
measure their capital needs using a tool that is designed for banks.
By way of analogy, it would be wholly inappropriate to apply an
insurance-centric capital framework on a group-wide basis to bank
holding companies, bank SIFIs like JP Morgan or Wells Fargo, or to
banks that each happened to own small insurance operations.
The Statutory Construction Issue
As you know, the purpose of the Collins Amendment is to ensure that
certain financial institutions are subject to a minimum capital
requirement. The economic crisis underscored the need to ensure that
financial institutions hold enough capital to weather severe economic
stress. We wholeheartedly support strong capital rules, which protect
financial institutions, the broader economy, and everyday Americans.
Again, we are not seeking lower capital requirements for insurers
or their depository institution subsidiaries. We only seek to ensure
that any capital standards established by the Federal Reserve utilize
appropriate methodologies and accurately reflect the risks inherent in
the business of insurance, which we believe is consistent with
Congress' intent in adopting the Collins Amendment.
We also believe that the plain language of the Collins Amendment
permits the Federal Reserve to establish a separate, tailored, group
capital framework for insurance SLHCs and insurance SIFIs. However, the
Federal Reserve has maintained an interpretation of the Collins
Amendment that constrains their ability to tailor the rules and would
require the imposition of bank-centric Basel capital rules on insurance
SLHCs and insurance SIFIs. Despite this interpretation, Federal Reserve
officials have repeatedly agreed with policymakers and industry
officials that a one-size-fits-all approach is undesirable.
We respectfully, but strongly, disagree with an interpretation of
the Collins Amendment that would prevent the Federal Reserve from
establishing a separate capital framework that is appropriately
tailored to the risks inherent in the business of insurance. Our
company and trade association comment letters articulate this view in
detail, as do several comment letters from respected attorneys who are
experts in the field. Of prominent note, the author of the Collins
Amendment, Senator Susan Collins, has stated that ``it was not
Congress's intent that Federal regulators supplant prudential State-
based insurance regulation with a bank-centric capital regime . . .
[C]onsideration should be given to the distinction between banks and
insurance companies . . . I believe it is consistent with my amendment
that these distinctions be recognized in the final rules.''\1\ We are
pleased that the Federal Reserve is still examining this issue
carefully and are hopeful that the agency will ultimately agree that
the existing statutory language provides sufficient flexibility to
establish a capital framework for insurance SLHCs and insurance SIFIs
that more accurately accounts for the unique risk and capital profiles
of insurers.
---------------------------------------------------------------------------
\1\ Letter from Senator Susan Collins to the Federal Reserve, the
Federal Deposit Insurance Corporation, and the Office of the
Comptroller of the Currency, November 26, 2012.
---------------------------------------------------------------------------
Support for a Legislative Solution
However, we are cognizant that if the Federal Reserve continues to
hold the view that the Collins Amendment prevents the agency from
establishing a tailored capital framework for insurance SLHCs and
insurance SIFIs, the result will be the application of bank standards
on insurers. This could have unintended negative consequences for
consumers, the insurance market, and the economy. For these reasons, we
support Congress passing legislation to clarify that the Federal
Reserve, consistent with the original intent of the Collins Amendment,
can and should establish a separate, tailored capital regime for
insurers that appropriately reflects the industry's unique business
model, risk profile, and asset-liability management practices.
Specifically, we support S. 1369, legislation introduced by
Senators Brown and Johanns last year which has a broad, bipartisan
group of cosponsors. S. 1369 would clarify that the Federal Reserve is
not required to impose a bank regime on insurers by exempting insurers
from the Collins Amendment. The bill would leave intact Sections 616
and 165 of the Dodd-Frank Act, which are the Federal Reserve's two
other sources of legal authority to impose robust capital standards on
insurers supervised by the Federal Reserve. In addition, under the
Brown-Johanns bill, Basel III banking standards would continue to
appropriately apply to depository institutions owned by an insurance
company. Simply put, the Brown-Johanns bill would not affect the
Federal Reserve's ability to impose group capital requirements on
insurers; it would only clarify that the agency has the authority to
tailor those standards to insurers' business models by utilizing the
appropriate tools.
We strongly support this legislation and applaud the bill's
sponsors for their leadership on this issue. We also greatly appreciate
the helpful involvement of Sen. Collins in the legislative effort. We
look forward to being part of any sensible solution that protects
policyholders without subjecting our companies to a capital framework
that was designed for banks and which is inappropriate for our business
model.
The Role of Nationwide Bank in Nationwide Enterprise
As an SLHC, Nationwide is subject to the Collins Amendment by
virtue of its ownership of Nationwide Bank. The same is true for the
other SLHCs, including TIAA-CREF, who is also testifying today.
As an insurance SLHC, Nationwide has opted to continue to offer
competitively priced, reliable banking products despite the obvious
regulatory costs. Nationwide's online bank represents a way to
supplement the insurance services we provide to our life and property
casualty members.
As an example, Nationwide Bank played a critical role in the
aftermath of the tornado that devastated Joplin, Missouri in 2011.
Nationwide was able to quickly make insurance claims payments through
Nationwide Bank debit cards issued to its policyholders who did not
have access to bricks-and-mortar banks and who desperately needed these
insurance payments in the wake of the disaster. The ability to offer
this type of product through Nationwide Bank helps our policyholders
get back on their feet sooner during a difficult situation.
Other insurance SLHCs have similar stories--we are not striving to
become large commercial banks, but rather, to provide important
complementary products to our insurance customers. Some insurers have
divested their banks; however, we believe strongly that it is in the
best interest of our customers (and indeed the banking system) to have
access to affordable retail banking products from the strong insurance
companies they trust.
The Bank-centric Basel III Framework is Inappropriate for Insurers
I'd now like to turn to why imposing a bank-centric capital regime
on insurers is inappropriate for assessing their capital adequacy.
The Basel Committee on Banking Supervision developed the Basel
banking capital regime, including its most recent iteration, Basel III,
specifically for banks and not insurers. At a very high level, the
Basel framework is almost entirely focused on the asset side of a
company's balance sheet, because in the banking industry, that is
primarily where risk resides. The predominant risks facing a banking
organization include credit risk, market risk, counterparty risk and
liquidity risk. As a result, an asset-based capital framework that is
primarily focused on a these risk types is suitable for assessing
capital for a banking organization.
However, Basel III, as implemented in the United States does not
provide for critically important differences in company liability
structures, liquidity profiles, or asset-liability management
requirements. Consequently, such banking frameworks are not appropriate
for insurers because they do not capture important liability based
insurance risks (and associated risk management practices) that must be
considered when determining capital requirements for such companies.
Relative to insurers, banking organizations tend to hold riskier
assets that are funded by short-term liabilities, making the
traditional banking model more sensitive to changes in asset prices and
vulnerable to a risk of runs on deposits and a pull-back from short-
term creditors in a very short period of time. Consequently, systemic
economic events can subject banks to destabilizing ``runs'' and force
them to quickly sell assets at a loss to meet their demand deposit
obligations and funding needs. Furthermore, without a sufficient level
of loss-absorbing capital, these banks would likely be unable to act as
a source of credit to the U.S. economy. Without an appropriate level of
capital, the fire sale of assets and pull-back of credit could have
further systemic implications. This occurred during the most recent
financial crisis due to the interconnectedness of the banking industry
with the rest of the financial system.
Conversely, the primary risks facing insurers, found on the
liability side of the balance sheet, are generally not as sensitive to
the same systemic economic risks. These insurer liability risks
include, for example, weather risk, mortality risk and morbidity risk.
Both life and property and casualty insurers invest upfront premium
payments in assets to satisfy liabilities that, by their nature, are
generally longer-term and typically dependent upon the occurrence of
uncertain events that are not highly correlated to macroeconomic
cycles.
While insurers are subject to asset risks based on the investments
held to meet long-dated liabilities, these risks do not expose
insurance companies to the same ``run'' scenarios as found in banking.
These asset risks manifest themselves in different ways for insurance
companies due to the nature of the insurance liabilities and asset
liability management practices which include accepting premiums up
front and investing them to meet future liabilities.
Again, property and casualty and life insurance policies are
typically payable only upon the occurrence of a certain idiosyncratic
trigger event not tied to economic cycles. While premature surrenders
of life insurance policies can occur, significant penalties discourage
this behavior and mitigate its impact. As a result, insurance policies
are not prone to sudden and widespread ``withdrawals'' as bank deposits
can be and, therefore, insurer liability and asset risks do not pose
the same systemic risk implications that are found in the business of
banking.
Imposing the Basel III Banking Framework Would be Potentially Harmful
to both the Insurance Industry and the Economy
In addition to being inappropriate for insurers, the Basel regime
is potentially harmful when applied to these companies because of their
distinct business models. Insurers hold longer duration assets than
banks. Insurers are significantly less reliant than banks on borrowed
debt, especially short-term debt, and do not require the same level of
liquidity as banks. However, insurance companies must engage in careful
asset-liability management to ensure policyholder are protected, a
business need the Basel regime also ignores.
One salient example of the inappropriateness of the Basel III
capital framework as applied to insurers is its 100 percent risk weight
to all corporate exposures, which fails to distinguish corporate
exposures based on the credit quality of the borrower. As has been
raised in comment letters, a 100 percent risk weight for investment-
grade corporate bonds held by insurers overstates the risk associated
with these assets, particularly when compared to a bank's commercial
and industrial loans, which are materially more risky but which receive
the same 100 percent risk weight. The insurance industry writ large has
substantially larger holdings of corporate bonds than banking, and is,
in fact, the largest investor in corporate bonds in the entire U.S
economy. As of year-end 2012, corporate bonds comprised about 48
percent of life insurer general account assets as compared to around 6
percent for banks. Corporate bonds can provide an effective investment
for meeting a long-dated policyholder obligation. Thus, overstating the
risk on such a substantial portion of an insurer's investment portfolio
will have a significant impact on insurance SLHCs and insurance SIFIs.
These companies would be required to hold more capital for these high-
quality investments, which could in turn impact the affordability and
availability of insurance products with long-term liabilities.
As an alternative to incurring high capital charges for investment-
grade corporate bond holdings, insurers subject to a Basel regime could
decide to take on additional credit risk by shifting their investment
portfolios to higher-yielding, lower-quality corporate bonds that would
receive the same 100 percent risk weight under the Basel III final
rule. Taking on additional credit risk would, as one would expect,
worsen the insurer's capital position under the State risk-based
capital framework, even though the insurer's capital adequacy would be
unchanged under the Basel III framework.
Simply put, the Basel III framework's 100 percent, ``one-size fits
all'' risk weight for corporate exposures provides a clear example of a
framework that was designed for banks, which do not invest heavily in
corporate bonds, and which is inappropriate for assessing the capital
needs of an insurance company.
The risk-weight for corporate bonds is just one example of why the
Basel regime is inappropriate and harmful as applied to insurers. There
are many others, including the regime's treatment of insurer separate
accounts, which we believe receive inappropriate treatment under the
Basel regime. These separate account assets would potentially receive
capital charges for risk not borne by the insurer, resulting in a
substantial and unreasonable capital cost which likely would impact
insurers' ability to offer these important products. Furthermore, the
risk weights applied in the Basel regime would over-charge for some
risks, entirely ignore others and potentially incent the wrong risk
measurement and therefore the wrong risk taking behavior. In total, it
is likely some insurers would be forced to hold excessive capital that
could cause a contraction in credit, and negatively affect availability
and affordability of many insurance products.
The State Risk-Based Capital Regime
The regulatory cornerstones to any discussion of group-wide
insurance capital requirements are the State risk-based capital (RBC)
models. Insurance is already heavily regulated by State law. Shortly
after the United States adopted the Basel I framework for banks in
1989, insurers became subject to the State RBC regime. The State RBC
framework actually consists of three distinct capital models, each
tailored to the unique risk profiles of life, property and casualty,
and health insurers separately. Each model determines the amount of
risk-based capital required by an insurance company given its
investment portfolio, business activities, and the liability risks it
has assumed. Regardless of what regime the Federal Reserve imposes on
insurers that are federally supervised, we will also continue to be
subject to State RBC requirements. We strongly support the RBC regime
and the appropriate capital standards it requires for each of the life,
property and casualty, and health insurance business models.
The RBC system places particular emphasis on policyholder
protection and the important differences between insurance business
risks. The purpose of the RBC regime is to provide customers and
regulators with a high degree of confidence that an insurer can pay all
claims over the entire duration of its insurance contracts in force.
Under the State RBC system, insurers hold capital to appropriately
reflect the risks of their assets and their liabilities (and indeed
potential mismatches between the two). The value of certain insurance
company liabilities (current and future claims) are measured by the
probability and severity of likely claims over a given period of time.
While insurance companies are in the business of managing risk, and
most do an excellent job of it, any capital regime such as Basel III
that does not properly reflect insurer liabilities and the insurance
business model has the potential to increase risk, not contain it.
Conclusion
Again, thank you for the opportunity to appear before you to
discuss our views on the appropriate capital regime for insurers. In
conclusion, I would like to reiterate a few important points. First, we
are not objecting to group supervision by the Federal Reserve. Second,
we are not objecting to the concept of comprehensive group capital
requirements for SLHCs or insurance SIFIs. Third, we are not objecting
to utilization of the Basel III framework for our bank. Finally, we are
not seeking lower capital standards--indeed we support strong
capitalization as part of our core business proposition. We are simply
advocating that there is no ``one size fits all'' model for assessing
risk and by extension no universally applicable framework for
determining capital requirements, that can be effectively applied
regardless of business model. We believe strongly that the Federal
Reserve should have the latitude to utilize any tool (or combination of
tools) necessary to effectively assess the risk profile, and therefore
capital requirements, of a holding company, taking into account
material differences in their business models. Therefore, we strongly
urge the passage of legislation that clarifies that the Federal Reserve
has the flexibility to tailor capital rules to insurance companies
under the agency's supervision. We thank you for the opportunity to
comment, and look forward to being part of a bipartisan policy solution
to this important issue.
Additional Material Supplied for the Record
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]