[Senate Hearing 114-94]
[From the U.S. Government Publishing Office]







                                                         S. Hrg. 114-94


           EXAMINING INSURANCE CAPITAL RULES AND FSOC PROCESS

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                    ONE HUNDRED FOURTEENTH CONGRESS

                             FIRST SESSION

                                   ON

EXAMINING THE FEDERAL RESERVE'S IMPLEMENTATION OF THE COLLINS AMENDMENT 
TO TAILOR CAPITAL RULES FOR INSURERS ON FSOC'S DESIGNATION PROCESS FOR 
 NONBANK SIFIS AND FOR INTERNATIONAL CAPITAL DEVELOPMENTS FOR INSURERS

                               __________

                             APRIL 30, 2015

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

MIKE CRAPO, Idaho                    SHERROD BROWN, Ohio
BOB CORKER, Tennessee                JACK REED, Rhode Island
DAVID VITTER, Louisiana              CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania      ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois                  JON TESTER, Montana
DEAN HELLER, Nevada                  MARK R. WARNER, Virginia
TIM SCOTT, South Carolina            JEFF MERKLEY, Oregon
BEN SASSE, Nebraska                  ELIZABETH WARREN, Massachusetts
TOM COTTON, Arkansas                 HEIDI HEITKAMP, North Dakota
MIKE ROUNDS, South Dakota            JOE DONNELLY, Indiana
JERRY MORAN, Kansas

           William D. Duhnke III, Staff Director and Counsel
                 Mark Powden, Democratic Staff Director
                       Dawn Ratliff, Chief Clerk
                      Troy Cornell, Hearing Clerk
                      Shelvin Simmons, IT Director
                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                      MIKE CRAPO, Idaho, Chairman

          MARK R. WARNER, Virginia, Ranking Democratic Member

BOB CORKER, Tennessee                JACK REED, Rhode Island
DAVID VITTER, Louisiana              CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania      ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois                  JON TESTER, Montana
TIM SCOTT, South Carolina            ELIZABETH WARREN, Massachusetts
BEN SASSE, Nebraska                  JOE DONNELLY, Indiana
JERRY MORAN, Kansas

               Gregg Richard, Subcommittee Staff Director
           Milan Dalal, Democratic Subcommittee Staff Director

                                  (ii)












                            C O N T E N T S

                              ----------                              

                        THURSDAY, APRIL 30, 2015

                                                                   Page

Opening statement of Chairman Crapo..............................     1

Opening statements, comments, or prepared statements of:
    Senator Warner...............................................     2

                               WITNESSES

Robert M. Falzon, Executive Vice President and Chief Financial 
  Officer, Prudential Financial, on behalf of the American 
  Council of Life Insurers and the American Insurance Association     3
    Prepared statement...........................................    20
Kurt Bock, Chief Executive Officer, COUNTRY Financial, on behalf 
  of PCI and NAMIC...............................................     5
    Prepared statement...........................................    26
    Response to written question of:
        Senator Vitter...........................................    59
Daniel Schwarcz, Professor and Solly Robins Distinguished 
  Research Fellow, University of Minnesota Law School............     7
    Prepared statement...........................................    55

              Additional Material Supplied for the Record

Prepared statement of Elizabeth Brill, Chairperson, Solvency 
  Committee Risk Management and Financial Reporting Council, 
  American Academy of Actuaries..................................    60
Prepared statement of the National Association of Professional 
  Insurance Agents...............................................    65

                                 (iii)
 
           EXAMINING INSURANCE CAPITAL RULES AND FSOC PROCESS

                              ----------                              


                        THURSDAY, APRIL 30, 2015

                                       U.S. Senate,
                     Subcommittee on Securities, Insurance,
                                            and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 10:02 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Mike Crapo, Chairman of the 
Subcommittee, presiding.

            OPENING STATEMENT OF CHAIRMAN MIKE CRAPO

    Senator Crapo. The hearing will come to order. Welcome, 
everyone, and, Senator Warner, welcome. Today's hearing will 
focus on the Federal Reserve's implementation of the Collins 
fix to tailor capital rules for insurers on FSOC's designation 
process for nonbank SIFIs and for international capital 
developments for insurers.
    Banking and insurance present different risk profiles, and 
Congress recently passed legislation to allow the Federal 
Reserve the ability to tailor holding company capital rules for 
insurers.
    The Federal Reserve needs to utilize this flexibility so 
that the proposed rule is consistent with the insurance 
business model and follows a formal rulemaking process to 
maximize opportunities for public comment.
    Last year, I requested that the Government Accountability 
Office initiate a study to examine the process FSOC uses when 
designating nonbank financial institutions as systemically 
important financial institutions. The report concluded that 
FSOC's process lacks transparency and accountability, 
insufficiently tracks data, and does not have a consistent 
methodology for determinations.
    I am interested in finding bipartisan solutions to ensure 
that FSOC is more transparent during the designation process 
about which activities, together or separately, pose the 
greatest risk from a company so that they can be addressed. 
That includes providing an off ramp or a way for a company to 
take action to mitigate or prevent the identified risk and to 
no longer be designated as a SIFI.
    The European Union and the International Association of 
Insurance Supervisors are undertaking separate initiatives that 
have raised concern also in the United States. The EU's 
Solvency II regulatory modernization program includes a 
reciprocity designation which some believe could disadvantage 
U.S. insurers if the United States is not judged a reciprocal 
jurisdiction. The IAIS, following a charge from the Financial 
Stability Board, is developing new capital standards for 
insurers.
    These developments raise several questions about the 
direction and timeliness given the regulatory differences 
between the United States and Europe. The American model for 
insurance regulation focuses on policy holder protections and 
is mainly State-based regulated while the European model is 
more focused on the impact of failure on the overall market in 
Europe. How will these standards likely impact consumers and 
State-based insurance regulation in the United States? If these 
standards are not compatible with our system, what will be our 
response? These and a number of other questions are critical 
for us to answer, and I look forward to the information that 
will be provided by our witnesses today.
    I also want to again take this opportunity to indicate how 
pleased I am to be working with Senator Warner today. We are 
closely coordinating, and I am confident that we can work 
together to find solutions that will help to address these 
issues.
    Senator Warner.

              STATEMENT OF SENATOR MARK R. WARNER

    Senator Warner. Thank you, Chairman Crapo, and thank you 
for holding this hearing. And let me also agree with you on 
your focus on SIFI designation and trying to make sure, as we 
talked at another hearing, that I do not think when we created 
the notion of SIFI that there was the ``Hotel California'' 
concern that once you check in you can never check out. We do 
think we need to figure out how SIFIs can--if institutions 
choose to try to leave that designation, that there is a clear 
and more transparent path.
    I also believe that the United States has a vital interest 
in the success of international organizations designed to 
improve financial supervision and stability. I think we all 
recall that the financial crisis of 2008 was global in nature 
and taught us that systemic risk does not respect geographic 
borders. The infamous AIGFP, the financial products unit 
structures derivatives that blew up AIG, was headquartered in 
London, for example. AIG's interconnected relationships as a 
counterparty with nearly every major in the United States 
threatened additional instability only a day after Lehman 
Brothers failed.
    The stark examples emanating from London is one of the 
reasons why I have supported increased cooperation amongst 
global regulators to coordinate regulations in response to 
risks posed to the economy and financial system by financial 
institutions. It is the principal reason why I held a hearing 
in this Committee in May 2013 assessing progress on cross-
border resolution.
    Understandably, much of the focus on cross-border activity 
is focused on how to treat derivatives and design adequate bank 
capital standards. I understand, however, that insurance, as 
the Chairman noted, is also receiving significant attention at 
the International Association of Insurance Supervisors in 
Europe.
    As our regulators pursue discussions at the IAIS, it is 
important to remember that the United States has a unique 
system of insurance regulation, as was mentioned by the 
Chairman, namely, State-based aimed at ensuring policyholders 
are made whole in the event of an insurance company's 
insolvency. This is why I raised a number of questions of the 
Federal Reserve and the Federal Insurance Office in a letter 
last year to determine how these organizations are taking the 
U.S. system into account while balancing the need for global 
cooperation and stability.
    Additionally, as some insurance firms now face Federal 
scrutiny as a result of owning thrifts or SIFI designation, it 
is important for the Federal Reserve to distinguish between the 
business of banking and the business of insurance. Again, I 
think this is an area where in the initial Dodd-Frank we 
perhaps went too far, and so I was pleased where Congress 
passed a fix, the so-called Collins amendment, last year to 
provide that appropriate flexibility to the Federal Reserve in 
implementing capital standards for insurance firms. I am eager 
to see how those standards will develop.
    Finally, as we look at how we can make the FSOC more 
transparent and as the FSOC continues to evaluate financial 
firms, including insurance companies, again, restating what I 
said earlier, the ultimate goal of SIFI designation is to 
reduce risk, not to simply create a whole new level of 
regulation.
    So I look forward to hearing from our witnesses, and, 
again, thank you, Mr. Chairman, for calling this hearing. And I 
think if we can find--if there is any group that can find 
bipartisan agreement, it will be us. Thank you, sir.
    Senator Crapo. Thank you, Senator Warner.
    We have three witnesses today: Mr. Robert Falzon, Executive 
Vice President and Chief Financial Officer of Prudential 
Financial, Incorporated; Mr. Kurt Bock, who is the Chief 
Executive Officer of COUNTRY Financial; and Mr. Daniel 
Schwarcz, a professor at the University of Minnesota Law 
School.
    Gentlemen, we welcome you all. We appreciate your taking 
your time and bringing to us your expertise. We would like to 
ask you to take no more than 5 minutes, if you will, to 
summarize your testimony. Your written testimony is a part of 
the record, and we would like to have plenty of opportunity to 
engage with you in questions and answers.
    With that, we will start with you, Mr. Falzon. Thank you.

  STATEMENT OF ROBERT M. FALZON, EXECUTIVE VICE PRESIDENT AND 
CHIEF FINANCIAL OFFICER, PRUDENTIAL FINANCIAL, ON BEHALF OF THE 
 AMERICAN COUNCIL OF LIFE INSURERS AND THE AMERICAN INSURANCE 
                          ASSOCIATION

    Mr. Falzon. Thank you. Chairman Crapo, Ranking Member 
Warner, Members of the Subcommittee, I am Rob Falzon, the Chief 
Financial Officer at Prudential Financial. As a domestic 
nonbank SIFI and an internationally active insurer, as well as 
a global SIFI, we cannot thank you enough for holding this 
oversight hearing on these important issues facing the 
insurance industry. Today I am here on behalf of the American 
Council of Life Insurers and the American Insurance 
Association.
    This morning, I will touch on three areas: first, the 
appropriate implementation of domestic capital standards for 
insurers under supervision of the Federal Reserve; second, 
developments in international supervision and capital 
standards; and, third, rationalization of the process of de-
designating nonbank SIFIs.
    The fundamental business proposition upon which insurance 
is built is that well-run and appropriately capitalized 
companies will be positioned to honor the commitments that we 
make to our customers for decades into the future and through 
all economic scenarios.
    Good regulation of insurance is critical to this 
proposition. If you have served on this Committee for a while, 
it has probably become apparent to you that we have not sought 
to eliminate appropriate oversight. Quite the contrary. We 
support a robust supervision and capital regime that provides 
our customers with confidence that we have the financial 
strength to keep our promises.
    However, with the supervisory power that is invested in our 
regulators comes the responsibility to ensure it is done 
appropriately, in a way that maps the specific risks we face to 
the regulatory constructs for holding capital and for managing 
those risks.
    Members of this Committee and this body showed a clear 
understanding of this last year when bipartisan legislation 
sponsored by Senators Brown, Johanns, and Collins was approved 
by unanimous consent and signed into law by the President. That 
bipartisan legislation, for which we appreciate every Member's 
support, did not eliminate the capital requirements called for 
in Dodd-Frank. Instead it simply clarified the Federal 
Reserve's authority to develop regulatory standards that 
reflect insurance businesses and risks rather than defaulting 
to mandatory, arbitrary, and inappropriate bank-centric 
standards that are completely disconnected to the risks of 
insurance.
    We have spent a lot of time with our new regulators at the 
Federal Reserve and are impressed with the professionalism and 
knowledge they have brought to this new area of jurisdiction. 
But with any new endeavor, especially one as different from the 
historic charge of regulating banks, the Federal Reserve needs 
ongoing and continued diligence in exploring, understanding, 
and getting it right.
    We are hopeful that in writing capital rules and 
supervisory standards for insurers the Federal Reserve will 
take the time provided through the Administrative Procedures 
Act to publish an Advance Notice of Proposed Rulemaking in 
order to gain as much as input as possible to ensure that these 
rules result in a world-class regime, one that properly 
captures risks and appropriately assesses capital.
    While the Federal Reserve is working on fulfilling its 
domestic capital mandate for insurers they supervise, there are 
also ongoing talks with the IAIS to develop a common global 
supervisory and capital framework for large international 
insurers. We believe it is important for the authorities from 
the United States to remain engaged in these standard-setting 
forums and to play an active role, effectively and successfully 
representing the interests of the U.S. insurance regulators, 
companies, consumers, and markets.
    While there was initial concern that an overly ambitious 
timeline set by the IAIS would rush into a judgment and a 
misaligned standard, we are pleased with reports that this 
timeline has been extended, affording U.S. authorities more 
time and latitude to develop appropriate domestic standards 
before finalizing a global framework. We strongly believe that 
all efforts should focus on getting domestic standards right 
before agreeing to any international standards. The lessons 
learned through a robust rulemaking process at home will only 
help to inform U.S. participants and provide them with valuable 
data and experience in shaping international standards.
    We would like to recognize that the U.S. participants--the 
Federal Reserve, the National Association of Insurance 
Commissioners, and Treasury--have made progress in advocating 
for appropriate standards. However, much work remains to be 
done and should only be done after first getting our standards 
completed at home.
    Last, I would like to address one other issue which the 
Committee explored at a hearing last month: FSOC's SIFI 
designations. As you are aware, Prudential was designated as a 
SIFI in 2013, thus subjecting us to Federal Reserve oversight 
for the first time in the company's 140-year history.
    We continue to disagree with the determination and believe 
that FSOC reached the wrong conclusion. However, what is not 
clear to us is what we can do to change the outcome or even to 
reduce our systemic footprint. Every year, we have an 
opportunity to petition FSOC to rescind the designation. We 
have done this. This designation, which requires the same super 
majority as that needed to designate, is an important provision 
and underscores that Dodd-Frank did not intend the SIFI 
designation to be permanent. However, more meaningful evidence 
to support the initial designation is both appropriate and 
needed to help companies understand why they were initially 
designated and what actions could be taken to be de-designated.
    We think one area where Dodd-Frank clearly could be 
strengthened in would be in requiring the FSOC, when it 
considers designating a company, to be much clearer in 
identifying the risk factors that are the cause for concern, 
and in the annual review to clearly articulate to companies the 
steps they can take to reduce their systemic footprint.
    Mr. Chairman, Ranking Member Warner, thank you, and I look 
forward to answering your questions.
    Senator Crapo. Thank you, Mr. Falzon.
    Mr. Bock.

   STATEMENT OF KURT BOCK, CHIEF EXECUTIVE OFFICER, COUNTRY 
             FINANCIAL, ON BEHALF OF PCI AND NAMIC

    Mr. Bock. Chairman Crapo, Ranking Member Warner, and 
Members of the Subcommittee, my name is Kurt Bock, Chief 
Executive Officer of COUNTRY Financial, an A-plus rated mutual 
company providing home, auto, business, life insurance, and 
investment services to Main Street America. I am testifying on 
behalf of PCI and NAMIC who together represent three-quarters 
of all property casualty insurers.
    COUNTRY is not a systemically important insurer, but what 
we are is important to almost 1 million households. I am also 
here on their behalf.
    Our insurance market faces unprecedented challenges from 
increased Federal and international intrusion into the U.S. 
State insurance regulatory structure. Though not perfect, the 
State system has successfully protected consumers for over 150 
years and has fostered the development of a property casualty 
insurance market that is highly competitive, extremely well 
capitalized, and very stable.
    Most importantly, our U.S. insurance system is consumer-
focused rather than creditor-centric in contrast to the banking 
system and many international insurance systems that we are 
being pressured to emulate.
    In the Dodd-Frank Act, Congress largely affirmed the 
primacy of State insurance regulation. However, Congress also 
abolished the Office of Thrift Supervision and transferred its 
authority over insurance holding companies with thrifts to the 
Federal Reserve, which has had numerous unintended 
consequences.
    COUNTRY Financial is a Main Street insurer that owns a very 
small thrift, only $30 million in assets, focused on wealth 
management for our customers. We have no transactional deposits 
or loans. Despite this minimal banking footprint, COUNTRY is 
now subject to Federal Reserve regulation, including detailed 
discovery questionnaires and regular visits by examiners that 
seek to learn all aspects of our businesses.
    Our industry has no complaints about the very professional 
Federal Reserve staff, but what we do wonder is whether 
Congress truly intended to create Fed supervision of Main 
Street insurers and whether the Fed's efforts can be more 
proportional to the banking risk involved.
    It is essential that the Fed get it right when it comes to 
setting a capital standard for companies they regulate, such as 
adopting an aggregate legal entity capital approach, relying on 
State-based measures and triggers.
    Our industry is also very concerned about international 
agencies that are trying to pressure the United States to 
compromise on global standards that would undermine our current 
U.S. regulatory system and its focus on consumer protection. 
When I hear our Federal representatives are overseas 
negotiating new global insurance standards, I really have to 
ask: What problem are they trying to fix? The chief mission of 
bodies such as the International Association of Insurance 
Supervisors ought to be to facilitate a stronger global 
insurance regulatory environment through cooperation and 
coordination, rather than attempting to create one-size-fits-
all requirements for every country in the world. One-size-fits-
all does not work in bathing suits or when devising global 
regulatory standards.
    Furthermore, IAIS decisions are largely made behind closed 
doors. Stakeholder comment letters, testimony, and debates with 
the IAIS seem to fall on deaf ears, with key decisions 
appearing to have been preordained. I hope you are as deeply 
concerned by this lack of transparency and accountability as I 
am.
    U.S. insurers have been told not to worry because these 
international standards do not have the force of law and must 
still be adopted domestically. However, we were also told there 
would be opportunities to debate the global designations of 
systemically important insurers, yet U.S. regulators have 
faithfully executed domestically every single SIFI designation 
that was agreed internationally, in some cases even over the 
strong objections of FSOC's insurance experts and the primary 
functional regulators.
    COUNTRY Financial and our trades focus starts and ends with 
the consumer, and it is not at all clear that the current 
domestic and international regulatory activities will benefit 
them in any way. Ultimately, there will be a cost which the 
policyholder will be asked to pay.
    We welcome your oversight and legislative involvement on 
these issues. One first step would be to pass the Policyholder 
Protection Act, introduced by Senators Vitter and Tester. This 
bill would ensure that Federal banking regulators cannot 
inappropriately use assets intended to protect insurance 
consumers to bail out other affiliated financial firms and that 
State regulators retain the power to resolve troubled insurers 
in the manner they judge most appropriate.
    We applaud Senators Heller and Tester for their leadership 
in discussing potential legislative reforms, and on behalf of 
NAMIC and PCI, but most importantly on behalf of all of our 
consumers, we would very much appreciate your involvement and 
action on these issues.
    I would be glad to answer any questions.
    Senator Crapo. Thank you very much, Mr. Bock.
    Mr. Schwarcz.

   STATEMENT OF DANIEL SCHWARCZ, PROFESSOR AND SOLLY ROBINS 
  DISTINGUISHED RESEARCH FELLOW, UNIVERSITY OF MINNESOTA LAW 
                             SCHOOL

    Mr. Schwarcz. Thank you very much, Chairman Crapo, Ranking 
Member Warner. Today I am going to talk about two issues 
paralleling my written testimony. The first issue I want to 
talk about is FSOC transparency.
    As you know, one of the core goals of Dodd-Frank was to 
ensure that firms that pose a systemic risk to the economy, 
like AIG, like Lehman Brothers, like Bear Stearns, are 
regulated appropriately in light of that fact.
    To accomplish that, Dodd-Frank created FSOC and entrusted 
FSOC with a flexible and adaptive approach to attempt to 
discern whether individual firms pose a systemic risk to the 
larger economy. That flexible and adaptive approach was born of 
experience, and that experience was that trying to 
formulaically define what types of institutions pose a systemic 
risk does not work. We thought we had done that well by saying 
that banks defined are systemically risky and firms like AIG 
that are just insurance companies are not. But the financial 
system is too fluid and too complicated to allow for simple, 
formulaic definitions of systemic risk.
    In that light, Dodd-Frank created FSOC and said consider 
all of these factors, including your own judgment, and on the 
basis of an individualized judgment, decide whether firms are 
systemically risky.
    I believe that that was appropriate, but it, of course, 
inevitably creates potential transparency concerns. And the 
reason for that is that any broad standard that allows for 
adaptability and flexibility is going to at the same time 
create some level of opacity.
    My view is that FSOC has done a reasonable job of balancing 
the inherent transparency concerns in its structure with 
transparency. The most important thing that I think FSOC has 
done that I think it is important to recognize is it created a 
quantitative screen at the front end whereby firms are not 
going to be designated as systemically significant, at least 
presumptively, if they do not meet certain quantitative 
thresholds. That provides substantial certainty to most nonbank 
financial firms that they are not systemically risky.
    It also has adopted additional reforms more recently to 
enhance transparency. Now, that is not to say that FSOC could 
not improve further, and I do support the idea that FSOC should 
be clearer in its designations about what types of activities 
and features of SIFIs render them a SIFI and what firms might 
be able to do to get out of SIFI designation.
    But what I want to caution against is the notion that clear 
formulas or clear quantitative thresholds can be enunciated 
such that firms can either avoid SIFI designation in the first 
place or achieve an off ramp.
    Systemic risk is not currently susceptible to easy, simple 
definitions, and that is why we have an expert body of 
financial regulators that we entrust to do a searching job. So 
while I support the idea of a process for firms to appeal the 
idea of SIFI designation and to ask whether specific reforms 
would allow them an off ramp, what I think we need to be 
careful to avoid is mandating some sort of clear off ramp that 
would be formulaic and that would not respect the need to 
engage in individualized risk assessment.
    The second issue I want to talk about with my brief time 
remaining involves capital standards. As you know, the Federal 
Reserve is entrusted with developing capital standards for 
firms that are designated as SIFIs as well as for insurance 
companies that own an FDIC-insured institution. That capital 
regime should indeed be designed in light of both the strengths 
and the weaknesses of the State risk-based capital framework. 
That framework works well to protect policyholders, I believe. 
But at the same time, it is not specifically designed to 
address systemic risk concerns. That is not the province 
traditionally of State insurance regulators.
    And so my view is that the Fed needs to design a capital 
regime that is appropriate to address systemic risk concerns. 
What would that mean? I believe that means that the Fed needs 
to start with a consolidated balance sheet. It needs to look 
through individual legal entities that are the structure of the 
risk-based capital framework and specifically avoid some of the 
potential shell games that can be played with individual legal 
entities that can be used to limit a risk.
    Moreover, I believe that the Fed framework needs to 
consider the possibility of valuing assets at market value, 
because when you are dealing with a systemic firm, part of your 
concern has to be about how would that systemic firm deal with 
a scenario in which it did have to liquidate its portfolio 
immediately.
    So for those reasons, I believe that it is appropriate for 
the Fed to engage with the IAIS and to take elements of the 
IAIS framework with it in terms of developing a broader 
standard.
    Thank you very much.
    Senator Crapo. Thank you very much, Mr. Schwarcz.
    Before I go to the questions, I have received statements 
from the American Academy of Actuaries and the National 
Association of Professional Insurance Agents, which I would 
like to enter into the record, without objection. Seeing none, 
they will be entered into the record.
    Senator Crapo. Let me start with a question. I just would 
like to ask a general question to the entire panel, and it is 
basically on the off-ramp question, which you each have 
discussed to some extent in your statements. And, by the way, I 
think that the information you presented both in your written 
testimony as well as what you have presented here today has 
been very helpful.
    The FSOC Member with Expertise, Mr. Woodall, has stated 
that FSOC should be more transparent during the designation 
process about which activities, together or separately, pose 
the greatest risk from a company so that they can be addressed, 
and each of you have discussed this in general. My question 
basically relates to whether there is an agreement from the 
panel or whether you have some further observations on the 
issue as to whether FSOC should specify the systemically risky 
activity that caused the company to be designated and how this 
could provide guidance or a road map to take action to mitigate 
or prevent the identified risk.
    Why don't we start with you, Mr. Falzon, if you have any 
response to that.
    Mr. Falzon. Thank you, Senator. So a couple of thoughts.
    First, we disagree with the designation of Prudential as 
being systemically risky. There is an annual process that is 
provided to us post-designation that allows us to petition 
against that designation. We have done that, and we will 
continue to do so. The frustration or challenge that we face is 
that lacking the justification for the on ramp, we lack the 
tools to define the off ramp. I hear the points that have been 
made by my colleague to the far left on the potential risks of 
being overly quantitative in that specification of the off 
ramp. However, I believe that if you are able to designate a 
company and define those characteristics that cause it to be 
systemic, you ought to similarly be able to designate those 
characteristics that would cause it to be less systemic.
    If you think about the objective of this regulation, it is 
not to simply classify companies as systemic and then box them 
in that and hold them into that designation for a long term 
but, rather, to encourage them to reduce those activities that 
are leading to systemic risk in the U.S. economy. Without the 
tools to identify the activities that give rise to that risk, 
we are unable to address appropriately our activities in a way 
that would be constructive and responsive to the intent of the 
regulation.
    Senator Crapo. Thank you.
    Mr. Bock?
    Mr. Bock. Thank you, Chairman. I will just preface this by 
saying we are in the business of managing risk, and to know the 
why and the how is always important to us. And we do a good job 
of managing it when we know the why, which I believe is one of 
the issues, and in terms of the lack of transparency of the 
process.
    Our concerns obviously come down to Main Street, and Main 
Street's concern is what would be next, what would be next in 
this process, because it appears that size is a part of the 
designation, not necessarily activities, and for us it really 
extends Fed oversight into activities that do not pose systemic 
risk. So for us our questions always are: What is going to be 
next?
    Senator Crapo. Thank you.
    Mr. Schwarcz?
    Mr. Schwarcz. I believe that in a case where you have an 
institution where there is a single activity that poses a 
systemic risk, then absolutely FSOC should specify that. But I 
also believe it to be the case that FSOC's opinions, at least 
with respect to certain institutions, have suggested that there 
are a number of activities that in the aggregate pose a risk.
    Now, I do believe that FSOC should be clearer about the 
relative importance of those activities in its overall 
designation. But I also think that when, for instance, you have 
five or six or seven different factors that are playing in, it 
is the interaction of those factors. And for that reason, it is 
harder to say, well, if you stop this activity, you are no 
longer systemic. That is why I support a more robust process 
for petitioning plans and saying, look, if we stop these two or 
three activities, or if we change our risk profile in this way, 
would this allow us an off ramp? I think that is the more 
appropriate approach.
    Senator Crapo. So if I understand you correctly, Mr. 
Schwarcz, you are suggesting that there be an ability for a 
designated company or a company that is in the process of being 
evaluated to engage with FSOC and to understand the factors 
that are being analyzed and engaging in an analysis or a 
discussion between the parties to determine whether changes in 
the risk factors could result in a different outcome, whether 
the designation has already occurred or whether the process is 
simply being analyzed.
    Mr. Schwarcz. Absolutely. I completely agree with that. I 
just think we need to be careful to recognize that these issues 
are very complex, and so sometimes it is going to be a dialogue 
back and forth, and it is not going to be something you can 
clearly define ex ante.
    Senator Crapo. My time has expired for my questions, but I 
do want to just ask, very quickly, Mr. Falzon, did you have 
that kind of experience with Prudential as the designation 
process moved forward?
    Mr. Falzon. No, we have not. And while I take the points 
mentioned that there may be a variety of activities that give 
rise to the designation, I believe that the FSOC has an 
obligation to provide a road map of whatever combination of 
criteria are necessary in order to de-risk the institution on a 
U.S. systemic basis.
    Senator Crapo. All right. Thank you.
    Senator Warner?
    Senator Warner. Mr. Chairman, I want to continue in this 
line of questioning, because when we had Secretary Lew here 
recently, I think we had pretty broad agreement from both sides 
of the aisle that there needed to be this clearer path to de-
designation. I think Professor Schwarcz's point is a good one, 
that because there is a variety of factors that go into this 
designation, it may not be a single metric that allows you to 
de-designate. And I guess one of the things that we have seen 
starting, I believe, around the turn of the year, FSOC 
internally and Treasury internally announced changes both in 
terms of trying to improve transparency. We had Secretary Lew 
here saying that he agreed with the sense that, again, back to 
my ``Hotel California'' analogy, that you should be able to 
check out even if you do get stuck checking in.
    And, Mr. Falzon, just recognizing that you have disagreed 
with the designation from its starting point and filed, have 
you seen any kind of change in approach in the last couple of 
months since it seems like the FSOC and Treasury have kind of 
been moving in this direction?
    Mr. Falzon. Our period for review for reaffirmation of the 
designation, our opportunity to petition is coming up in late 
summer or early fall of this year. We have just received 
notice, I believe, that, in fact, this process has begun. So we 
have not had the opportunity to see a change in behavior since 
the first time that we petitioned was in advance of the 
hearings that you just referenced.
    I would hope that there would be a change in conduct. I 
have not yet seen evidence of that.
    Senator Warner. What about in terms of--there also seemed 
to be a greater acknowledgment that there needed to be more 
iterative back-and-forth as you even go through the designation 
process, so, again, more conversation. Have you seen any of 
those changes to date?
    Mr. Falzon. We have not been a participant in any of the 
conversations. Now, recognize that we have already been 
designated, and, therefore, our opportunity to engage in a 
dialogue in advance of designation has already passed. So what 
we are hopeful is that that dialogue would occur in the context 
of the annual reviews in which we have this petition 
opportunity. Again, we have not yet seen that, but there is 
time between now and when that comes up for formal review.
    Senator Warner. I guess one thing I would also like to ask 
comments from the whole panel is I think one of the things that 
we have seen progress is that there is a growing recognition 
from the Fed and others that the insurance business is 
different than the banking business, and, you know, one of the 
tools that I think most of the banks would concur with is that 
the process of the stress tests have been effective and are a 
good measuring tool.
    How do we go about and how do you think any kind of general 
comments about a stress test on the insurance side of the 
ledger that could be as effective as it has proven to be on the 
banking side? Just quickly going down the whole panel.
    Mr. Falzon. Yes, that is an excellent question. Let me 
reiterate the very point that you made. In our interactions 
with the Fed, particularly post the passage of the Collins 
amendment fix, we have actually seen a marked difference in our 
interactions with the Fed, and it is much more open and 
constructive, and we have welcomed that. So there has been a 
visible difference.
    With regard to stress testing, stress testing applies to 
insurance companies just as it applies to banks. Stress testing 
is different for an insurance company than it is for a bank. 
You need to look at a combination of market stresses and 
insurance stresses, and you need to recognize that those 
stresses typically do not manifest themselves in the very short 
term. There are certain risks that we take that would manifest 
themselves in the short term, catastrophic risk by way of 
example. But many of the risks we take are associated with 
long-term liabilities, things like life insurance. That is a 
mortality risk. The evidence as to whether that mortality risk 
was appropriately taken or not will be very far into the 
future. And so as you think about stress testing, you need to 
think about adapting it to the very specific risks that we 
take.
    We do believe that there is a single construct that you can 
use for the insurance industry that would capture the variety 
of risks that insurers take by having bespoke inputs into that 
construct. And we are working across the life and P&C industry 
in order to develop that construct and bring it in a proposal 
to the Federal Reserve .
    Senator Warner. Very briefly, Mr. Bock and Dr. Schwarcz.
    Mr. Bock. Thank you, sir. For us, obviously it is 
important, as you have all recognized, to understand that 
insurance is different than banking. But also property/casualty 
companies are different than life. Our issues and stress are 
always different, and liquidity is something that is not an 
issue for us in terms of our stresses. But we do ensure that we 
follow those insurance risks through our modeling, cap 
modeling, et cetera, to make sure that obviously we protect our 
policyholders, which is the goal of our testing.
    Mr. Schwarcz. Absolutely, I think stress testing is very 
important. I think the difference is the Fed needs to stress-
test specific to systemic circumstances, and so the types of 
stresses that it is going to consider are stresses to the 
broader financial system that occur simultaneously with 
stresses to the firm.
    The other point I would like to make is it is absolutely 
true that most of the time life insurers' liabilities are long 
term. But the very reason or one of the core reasons why firms 
get designated as SIFIs even though they engage predominantly 
in insurance is because liabilities that seem long term and 
usually are long term can become short term in systemic 
scenarios. For instance, policyholders can cash out or 
surrender; guaranteed investment contracts can be canceled. So 
stress testing for SIFIs needs to specifically look at the 
possibility that otherwise long-term liabilities will become 
short term and ask whether or not the firm can handle that 
given the sort of dominant assumption that in most times the 
liabilities are very long term and predictable.
    Mr. Falzon. Senator, I need to object to the observation 
that was just made. I think that both the review process for 
Prudential as a designation as a SIFI and that that was done 
for Metropolitan Life, we demonstrated with a body of evidence 
that, in fact, the acceleration of liabilities on an insurance 
company's balance sheet does not give rise to systemic risk 
and, in fact, has been fairly modest. The evidence does not 
support the conjecture of that argument.
    Mr. Schwarcz. Can I just say one thing? Much of the 
information is not in the public domain, so I cannot say one 
way or another whether that is right.
    What I can say is that the FSOC decided in its public basis 
that indeed there was systemic risk associated with the 
possibility of a run on--and that was one of the bases of its 
designation. So I cannot personally say whether that is right. 
I have not gone through the books. They are not available to 
me. But FSOC has indicated that is one of the reasons why both 
Prudential and MetLife were designated, and for that reason, 
stress tests need to take that into account.
    Senator Warner. Thank you, Mr. Chairman. I hope we get a 
second round. I have got a couple more questions I would like 
to ask.
    Senator Crapo. We will.
    Senator Warren?
    Senator Warren. Thank you very much, Mr. Chairman.
    You know, Congress is debating whether to give the 
President fast-track authority, that would reduce Congress' 
ability to shape major trade agreements. The fast-track bill 
would give the President that authority potentially through 
2021, and that means that fast track would apply not only to 
TPP in Asia but also to the TTIP, the trade deal that we are 
currently negotiating with the European Union.
    Now, one of my concerns about fast track is that a future 
President could use it to negotiate a TTIP agreement that 
weakens our financial rules or disrupts our regulatory system. 
The European approach to regulation is different from our own 
in many respects, and harmonizing our rules in a trade deal 
could mean real problems in regulating our financial services 
industry.
    Take insurance regulation, for example, what we are talking 
about here today. The International Association of Insurance 
Supervisors, or IAIS, is working on finalizing new capital 
standards for ``internationally active insurance groups.'' But 
Europe and the United States have very different approaches to 
regulating insurers with Europe using higher capital standards 
and the United States using reinsurance to protect 
policyholders.
    So, Mr. Falzon, could you describe how the European 
regulatory approach compares to the American regulatory 
approach and how those differences affect how European and U.S. 
insurers operate? Briefly, if you could.
    Mr. Falzon. Very briefly, first, we do support the 
engagement on the U.S. side in the international development of 
a global set of standards. We would note that the United States 
is the largest insurance market in the world, and, in fact, as 
was heard in earlier testimony to this Committee, if you took 
the top 50 insurance markets and you made each individual State 
a market, we would account for 26 of the largest 50 insurance 
markets in the world.
    Senator Warren. I am asking about the difference, though, 
in the regulatory approach.
    Mr. Falzon. Yeah, so the point being, however, that we 
should be leading in the development of these global standards. 
In terms of the differences, the European model is based on a 
system of the business model that they have and the accounting 
constructs that they have. Now, that accounting construct is 
something called IFRS, very different than U.S. GAAP. It has a 
marked-to-market concept embedded within it, and it leads to a 
type of accounting which is not well suited to the products 
that we deliver in the United States, particularly those 
products in the insurance arena which are long term and 
demonstrate enormous volatility if you begin to mark them to 
market.
    Senator Warren. OK. Very helpful.
    Professor Schwarcz, so you think it makes sense for the Fed 
and our State insurance regulators to tailor those capital 
standards to fit the existing regulatory structure in the 
United States?
    Mr. Schwarcz. Absolutely, I do, and I think that the way 
that that needs to be done is for the Fed to consider 
specifically the ways in which the State risk-based capital 
regime is focused on policyholder protection, and to then say, 
OK, well, what do we need to do to supplement that regime to 
bring a macroprudential perspective, a systemic risk 
perspective?
    So I think that that question of how to supplement is one 
that requires being very cognizant of the unique regulatory 
regime we have and building on that regime to address different 
concerns than those that are at the core of what State 
insurance regulators do.
    Senator Warren. Good. Thank you. That is very helpful. I 
believe in strong capital standards for financial institutions, 
but I am glad that in the case of IAIS capital standards, there 
is going to be an opportunity for our regulators to tailor 
those standards to fit the American approach to regulation.
    What alarms me is that if regulatory changes are included 
in a future trade deal with the EU, that opportunity for 
tailoring disappears. We have stronger financial rules than the 
EU in many areas. If Congress passes fast track now and a 
future President in 2018 or 2020 agrees to weaken financial 
rules as part of the trade deal with Europe, it will take only 
51 votes in the Senate to make those changes the law.
    That should worry anyone who supported Dodd-Frank and who 
believes that we need strong rules to prevent the next 
financial crisis. So thank you all for being here.
    Thank you, Mr. Chairman.
    Senator Crapo. Thank you, Senator Warner and Senator 
Warren. We have got both of you sitting here.
    I want to pursue the same line of thinking just from a 
little different angle, and that is with regard to 
international capital standards. Two of the three insurance 
companies that FSOC has designated as systemically important 
were first designated by the international Financial Stability 
Board, and because three voting members of FSOC first engaged 
at the international FSB level to determine if a U.S. company 
is systemically important, there is a concern that the FSOC 
designation for those companies was predetermined essentially 
and that something very similar is going to occur now as we 
deal with capital standards.
    This is something that, Mr. Bock, you raised in your 
testimony, and so I want to go to you first. But before I do 
so, I guess the question is: Is this a valid concern? And do 
these developments raise questions about the direction and 
timeliness given the regulatory differences between the United 
States and European models? Mr. Bock, we will start with you, 
and then let us go to Mr. Schwarcz and Mr. Falzon.
    Mr. Bock. Thanks, Mr. Chairman. Obviously, as Senator 
Warren indicated and as you have heard many times, there is a 
tremendous difference between our systems. The timetables and 
regulations really should not be driven by international 
pressures. We certainly have to recognize the State system in 
the United States has been a valuable system, has protected 
U.S. consumers for 150 years. So our concern is that, yes, it 
is being driven fast, and we have not gotten our Federal 
standard in front of us yet to even understand that. So for us, 
the concern that you have is the same concerns that we have.
    Senator Crapo. Thank you.
    Mr. Schwarcz?
    Mr. Schwarcz. So I guess I would distinguish between 
designating a firm as systemically significant and then capital 
rules. Whether or not a firm is systemically significant I 
think should be a question that the Europeans have just as much 
insight in as we do. I mean, the question is really one of, to 
the extent a firm failed in a sort of weak financial setting, 
would that have broader consequences in the financial system. 
So I think it is appropriate in that context to learn from what 
the Europeans think and what other people in the international 
community think. That should not preordain our conclusion, but 
absolutely I think it should inform it.
    My understanding is that that is exactly what happened, 
that it informed our decision, but it did not in any way 
preordain it.
    To distinguish the capital question, when you are talking 
about, OK, exactly how should you implement capital rules, that 
is a question that, I think as we have discussed earlier in 
this hearing and as Senator Warren's question raised, one needs 
to implement capital standards in a particular jurisdiction 
that are reflective of the broader regulatory system.
    So I absolutely, again, think we need to learn from the 
IAIS. We need to learn from our international colleagues. There 
are some elements of the capital regime they are developing 
that I think should be incorporated. But I think that we cannot 
sort of adopt wholesale the views that they are developing, and 
I do not think that is what will happen. But I do think we need 
to learn from them and take them seriously.
    Senator Crapo. Thank you.
    Mr. Falzon?
    Mr. Falzon. It is difficult to compare or to speculate as 
to whether the designation internationally influenced the 
domestic designations because both processes lacked 
transparency. And, in fact, the global process has no 
transparency whatsoever. We had a single conference call that 
we were involved in in the process of that entire designation, 
and so we are not part of a hearing or an opportunity to 
present or appeal. So difficult to speculate.
    With respect to our regulatory system, I would share the 
observation that we have a strong system in place that actually 
on the whole has done quite well in the United States and that 
we should be leveraging that, plugging the gaps that exist in 
that system, when we think about things around group 
supervision that were evidenced as areas of weakness through 
the crisis, but that basic construct enhance, in order to 
provide the systemic protection that we all agree is important, 
should then be developed and exported as opposed to relying on 
a convention that is developed in an international arena to be 
imported into our marketplace.
    Senator Crapo. Well, thank you. This is very helpful. It is 
a very important discussion. As Senator Warren's comments 
indicate, there is a concern that this interaction between the 
U.S. and European models, through trade negotiations or 
otherwise, may be utilized to weaken U.S. standards. I hear the 
same thing argued from the other side, folks worried that it 
may be utilized to force the United States to adopt standards 
or designations that we did not want to nor need to adopt. So 
it is a very interesting conversation and a problematic issue 
that we need to get resolved properly.
    Senator Warner?
    Senator Warner. Thank you, Mr. Chairman. While Senator 
Warren and I differ on the trade approach, I concur she raises 
an interesting question that I have not fully thought through 
and think we need to get some answers on.
    I have kind of two slightly off-topic questions. One is we 
have had this extraordinarily low interest rate environment for 
some time and potentially foreseeably into the future. What 
does that do in terms of your balance sheet risks? I mean, 
obviously there is a lot of good things about that low interest 
rate phenomenon, but for the insurance industry it poses a 
different series of risks. Again, if very briefly we could get 
some response.
    Mr. Falzon. So low interest rates are a challenge for the 
industry in that it reduces our long-term profitability should 
it be sustained in our return on equity.
    From a balance sheet standpoint, however, the risk of low 
interest rates already sits on our balance sheet. Statutory 
reserving requires that we do a stress test on low interest 
rates, and in that stress test we dramatically lower the level 
of rates from where they are today and presume that they stay 
at the depressed level over a lifetime.
    The reserve that gets created by virtue of that scenario 
then has to be booked onto our balance sheet and backed with 
real hard financial assets. So from a balance sheet standpoint, 
the risk of sustained low interest rates has already been 
reflected and accounted for, and we are well suited to protect 
our customer obligations and to prevent any systemic 
consequences of that environment prevailing for a longer period 
of time.
    Senator Warner. Mr. Bock and Professor Schwarcz?
    Mr. Bock. Thank you, Senator. The challenge obviously, as 
you know, it does compress margins. One of the challenges 
obviously is not to reach for risk in order to generate income. 
We do not do that. As a mutual company, we take care of our 
policyholders first, and that means we do the appropriate 
things to manage in an unprecedented low interest rate 
environment.
    Mr. Schwarcz. I generally agree with what has been stated. 
The one thing I do want to sort of emphasize is that there are 
certain elements of the State regime, particularly the 
reserving regime, that do, in fact, protect policyholders, but 
there is also some change afoot with respect to how companies 
book reserves, and that is going to allow greater use of 
internal models. And then there has also been a very broad 
phenomenon of what some people call ``shadow insurance,'' where 
firms have been taking lower reserves by using affiliate 
transactions.
    So one of the core things that the Fed needs to do, I 
believe, in its supervision and perhaps in its capital 
requirements is to make sure that the types of protections that 
we have seen historically are not gamed or are not traded away 
with new regimes that are not time-tested.
    Senator Warner. Well, I want to make sure we get to Senator 
Scott, so I will just ask, Professor Schwarcz, if you want to 
just add one other comment. The NAIC witness last week raised 
similar concerns that there are--I share the fact that they are 
a very different business than the banking industry. But we 
have seen insurers start to move to more alternative investment 
products, use of hedge funds, other kind of things that fall 
out of the plain vanilla formula. Do you want to make a comment 
about that? I think that does raise concerns on my----
    Mr. Schwarcz. Absolutely. I think one of the core lessons 
of the crisis is that the financial system is constantly 
evolving, and very sophisticated firms are engaging in 
transactions that look a lot more like banking. So, for 
instance, we are seeing some funding agreements that FSOC has 
pointed out that creates short-term liabilities, securities 
lending that can create some short-term liabilities and bank-
run-like dynamics. We have guaranteed investment contracts that 
in some ways create guarantees that can create long-term 
concern and liquidity concerns.
    So I think that it is important that we are cognizant of 
the fact that while the core insurance business is very 
different than the core banking business, insurers are, at 
least in many cases, engaging in activities that are closer on 
the spectrum to banking or in between. And that is why we need 
to have a flexible and adaptive regulatory system rather than 
one that embraces very formulaic, quantitative standards.
    Senator Warner. Thank you.
    Thank you, Mr. Chairman.
    Senator Crapo. Thank you.
    Senator Scott.
    Senator Scott. Thank you, Mr. Chairman. I was just in a tax 
working group before I came here, so I think it is a good point 
that while we examine insurance regulation here and banking, we 
also keep in mind the unique insurance provisions in our Tax 
Code and how they impact companies and policyholders. Thank 
you, panelists, for being a part of this discussion this 
morning.
    I think sometimes it is easy for us here in Washington to 
get caught up in the alphabet soup of financial regulators and 
discussions about complex Dodd-Frank regulations and 
provisions. All of these are very important, but I would like 
to take a step back and just recall that what we are talking 
about today really all boils down to how it affects the 
policyholder.
    I learned from my time in the insurance industry of about 
25 years that there are a few variables when it comes to 
products: the terms of the insurance and the price. And I also 
learned that there are all kinds of people with all kinds of 
insurance needs. So I think it is important that our discussion 
focus on the availability and the flexibility of a diverse set 
of insurance products.
    And I worry that if we fail to shape regulation around the 
bedrock principle of policyholder protection that has served 
our State-based system so well for so long, we are going to 
eliminate products from the market or make them so expensive 
for average folks to afford.
    Mr. Bock, do you have any thoughts about this? And can you 
help me bring this Washingtonspeak down to a kitchen table 
economics point of view?
    Mr. Bock. Well, let me try to do what others failed to do. 
Obviously, for our industry, for the property and casualty 
industry, it is important to protect the policyholder, to keep 
our promises, and you have seen our capital, our surplus to 
premium go up. We have more surplus now to be able to take care 
of our policyholders in this industry than ever before. That is 
important. Anything that would put that at risk is actually 
putting our customers at risk, our consumers at risk, because 
as you did say, it would cause us to have to pass on whatever 
price it might be--the price of additional efforts in order to 
raise capital, to raise ourselves to levels that would limit us 
from doing what we need to do to take care of our customers. 
So, to me, I fully agree.
    The one thing that we are concerned about obviously with 
all the alphabet soup, as you say, is that in all this we do 
not think goals are aligned, and for us, in our company, when 
our goals are aligned, our customers are served, our consumers 
are taken care of. And regulatory bodies should be no 
different, and this is an area of our concern. We do not think 
our regulatory bodies are aligned.
    Senator Scott. The lack of expertise in some of our 
regulatory bodies may be part of the reason why they are not 
aligned.
    Mr. Bock. Absolutely. And we do look to you, we do look to 
our elected officials to give them the guidance that they need.
    Senator Scott. Thank you.
    Mr. Falzon, obviously Prudential has been designated as a 
SIFI by the FSOC, which subjects them to additional regulation 
by the Fed. On Tuesday, I asked Mr. Woodall about Prudential's 
designation and whether he agreed with me that regulators with 
experience in an industry should have a greater say in whether 
to designate a company in that industry. Obviously, Mr. Woodall 
dissented very forcefully from the Prudential designation 
decision.
    You touched on this during your testimony. Could you 
elaborate on this? And do you have any concrete ideas for 
reforming the designation process to give greater weight to 
regulators with experience in the industry?
    Mr. Falzon. We have engaged in the request for commentary 
on the FSOC process and have made a number of suggestions. In 
those suggestions, the theme that would run throughout that is 
increased transparency, increased interaction and dialogue, and 
clarity around the basis of designation. And we think 
addressing each of those and the variety of specific 
initiatives they could do in order to accomplish that would be 
helpful to coming to the right conclusions, that the 
transparency and interaction would include the input from 
experts. And whether the experts are part of that process in 
the form of voting members or part of that process in the form 
of expert testimony, we think that that would enhance the 
overall designation process.
    Senator Scott. Thank you. One of the points I wanted to 
convey during this hearing is that as we struggle with the 
right regulatory environment, the expertise in the industry 
that you are regulating seems to be incredibly important and 
oftentimes missing. And if we are going to make sure that the 
goal, the objective is to protect the policyholder, perhaps we 
should start with the policyholder and work our way back to the 
regulatory environment as opposed to transposing banking 
regulatory environment over the insurance industry in a way 
that is inconsistent with the best interests long term of the 
policyholder.
    Thank you.
    Senator Crapo. Well, thank you, Senator Scott, and I can 
speak for myself that at the level of this Committee and 
Congress, we are really glad to have someone with expertise in 
this industry to talk with us and work with us, and we 
appreciate your contribution.
    Senator Scott. Thank you. I am glad I have Travis with me, 
too. Thank you.
    [Laughter.]
    Senator Crapo. I have no further questions. Senator Warner, 
Senator Scott, do you have any further questions?
    Senator Scott. No, sir. Back to the working group.
    Senator Crapo. All right. Well, we want to thank this 
panel. I have said this already, but your written testimony as 
well as your presentations today have been very helpful. We 
obviously have some very significant issues to deal with, and 
this Committee is going to be grappling with those issues, and 
what you have helped us to understand today will be very 
beneficial in that regard.
    Without anything further, this hearing is adjourned.
    [Whereupon, at 11 a.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]
                 PREPARED STATEMENT OF ROBERT M. FALZON
   Executive Vice President and Chief Financial Officer, Prudential 
                               Financial
  on behalf of the American Council of Life Insurers and the American 
                         Insurance Association
                             April 30, 2015
    Chairman Crapo and Ranking Member Warner, my name is Robert Falzon, 
and I am Executive Vice President and Chief Financial Officer of 
Prudential Financial. I am testifying today on behalf of the American 
Council of Life Insurers (``ACLI'') and the American Insurance 
Association (``AIA''). ACLI is the principal trade association for U.S. 
life insurance companies with approximately 300 member companies 
operating in the United States and abroad. ACLI member companies offer 
life insurance, annuities, reinsurance, long-term care and disability 
income insurance, and represent more than 90 percent of industry assets 
and premiums. The American Insurance Association (AIA) is the leading 
U.S. property-casualty insurer trade organization, representing 
approximately 325 insurers that write more than $127 billion in U.S. 
premiums each year. AIA member companies offer all types of property--
casualty insurance, including personal and commercial auto insurance, 
commercial property and liability coverage for small businesses, 
workers' compensation, homeowners' insurance, medical malpractice 
coverage, and product liability insurance.
    ACLI and AIA appreciate the opportunity to address the ongoing 
development of capital rules by the Federal Reserve Board (the 
``Board'') applicable to those insurers that have been designated as 
systemically important by the Financial Stability Oversight Council 
(``FSOC'') or that own savings and loan associations, the related group 
insurance capital standard being developed by the International 
Association of Insurance Supervisors (``IAIS''), and the transparency 
and fairness of the FSOC designation process.
    Prudential Financial is one of the three insurers that has been 
designated as systemically important by FSOC, and as a consequence my 
company was intimately involved with the legislation enacted late last 
year enabling the Board to craft capital standards suitable for an 
insurance enterprise. In addition, I am personally involved in the 
overall industry effort to work with the Board to come up with the 
actual capital rules that will be applied to those insurance groups now 
subject to the Board's jurisdiction.
The Collins Amendment & The Insurance Capital Standards Clarification 
        Act
    Please allow me to thank Chairman Crapo, Ranking Member Warner and 
the Members of this Subcommittee for your leadership in support of the 
Insurance Capital Standards Clarification Act of 2014. As you know, 
this legislation, authored by Senator Susan Collins, Senator Sherrod 
Brown, Senator Mike Johanns, Representative Gary Miller, and 
Representative Carolyn McCarthy, was unanimously approved by the Senate 
and House last year. This essential legislation clarified Federal 
Reserve Board authority to develop capital standards for insurance 
companies subject to Board supervision that reflect insurance 
businesses and risks, rather than defaulting to inappropriate bank 
standards. The unanimous support for this legislation in both the 
Senate and House constituted a definitive statement of Congressional 
intent that insurance capital standards must be appropriately designed 
and tailored. The legislation was also an important recognition that 
the business of insurance is substantially and fundamentally different 
from the business of banking, and that supervision of these different 
industries, particularly where capital adequacy is being assessed, 
should account for their different risk profiles, balance sheets, and 
business models.
    Without question, capital standards are stronger when they are 
appropriately designed for the type of company to which they are 
applied. Appropriately designed and tailored capital standards further 
the goals of prudential supervision and provide the highest level of 
safety and protection for consumers. In the case of insurance, the 
application of bank standards would have disrupted the operations of 
well capitalized insurance companies. In fact, capital standards 
governing banks and bank holding companies should never be applied to 
insurance entities.
    In the near future, we expect that the Board will begin drafting a 
proposed regulation establishing a consolidated group capital standard 
for insurers that are savings and loan holding companies, or that have 
been designated by the FSOC as systemically important. Earlier this 
year, we met with senior representatives of the Board to stress the 
importance of moving forward with a proposal that reflects the well 
established methodologies for measuring the financial strength and 
resiliency of an insurance group. We have continued our communications 
with the Board's staff on the issue since then, and will continue to do 
so as this process unfolds. Since the passage of the Act, we are 
encouraged by the Board's approach to the issue and are hopeful that 
any proposed regulation will reflect the clear Congressional intent 
behind its passage.
International Insurance Capital Standards
    The International Association of Insurance Supervisors (IAIS) is 
working to develop an international group Insurance Capital Standard 
(ICS) as part of IAIS work on a proposed Common Framework for the 
Supervision of Internationally Active Insurance Groups (ComFrame). 
ComFrame is a set of international supervisory standards focusing on 
group-wide supervision of Internationally Active Insurance Groups 
(IAIGs). Under the current proposed ComFrame definition of an IAIG, 
there are likely to be approximately 50 IAIGs around the world. IAIGs 
are defined as companies that operate in three or more countries, 
generate more than 10 percent of their revenue from outside their home 
country, and meet significant size requirements.
    The U.S. insurance industry is concerned about the haste with which 
the ICS is being developed, particularly in the context of Congress' 
passage into law of the Insurance Capital Standards Clarification Act 
in December 2014. The IAIS timeline must accommodate full 
implementation of that law and a formal rulemaking process for 
development of domestic insurance capital standards by the Board.
    The IAIS recently announced that it will take a staged or 
incremental approach to developing the ICS over several years with the 
ultimate goal of global convergence around one standard in the longer 
term. This signals a longer, rational and thoughtful process to 
developing the ICS than originally identified. With that said, we will 
not grow complacent, we have not claimed victory--we will continue to 
actively engage our U.S. representatives to the IAIS as well as 
international supervisors to make sure that they remain true to a more 
deliberative approach to ICS development--one that reflects a capital/
solvency framework that is appropriate for the U.S. insurance market 
and consumers.
    The U.S. representative members of the IAIS will be informed by a 
deliberative rulemaking process by the Board that draws on the risk-
based capital framework currently utilized by the States, and they will 
bring that experience to bear in the international process. The IAIS 
timeline should not be elevated above the importance of developing an 
international standard that is complementary to local capital standards 
and results in a level competitive playing field that promotes private 
market expansion around the world. The ICS would clearly benefit from 
the work of the Board, and the insurance industry supports appropriate 
adjustments to the IAIS timeline for the ICS to accomplish these 
objectives. Importantly, the IAIS has slowed its overly aggressive 
timeline for development of the ICS, which can only be implemented 
through a State or Federal rulemaking process.
    Any ICS must be rooted in principles that are common to insurance 
in all jurisdictions, but must also be flexible enough to recognize and 
appropriately reflect existing accounting practices and the need for 
jurisdictional differences based on market, societal and consumer 
needs. Such flexibility is an essential precondition to the United 
States and other jurisdictions' willingness and political ability to 
adopt it into law and put it into practice.
    In fact, Team USA, consisting of the Board, State Insurance 
Supervisors, and the Treasury Department's Federal Insurance Office 
(FIO), has been forcefully advocating that any ICS cannot be finalized 
that does not allow for the foundational elements of the U.S. 
regulatory system. We understand that the IAIS will begin field testing 
two different approaches to the ICS this year. One of these approaches 
was largely developed, advanced and endorsed by all members of Team USA 
and is more representative of the U.S. regulatory framework. These two 
approaches will be field tested by more than 25 global firms, including 
several U.S.-based companies, over the next several years. This is 
another positive step. We commend the Board, State Insurance 
Supervisors, and FIO for working together to achieve this outcome.
    Another factor slowing the pace of ICS development is a realization 
by policymakers in markets around the world that life insurers not only 
meet a tremendous social need for protecting individuals and their 
families, but also are fundamentally important as one of the few 
industries that invest for the long term in infrastructure. Those 
investments are key drivers of global job creation and economic growth. 
We believe that it is critical for the United States to elevate this 
issue to the political level of the G20. The balance of regulatory 
intensity and investment and growth needs to be made at the macro 
political and economic level and not only by regulators who are not 
responsible for job creation and economic recovery. In a similar way, 
property-casualty companies provide the insurance that makes 
infrastructure development possible, as well as investments that 
support continued growth. It is critical that capital standards promote 
those roles to the benefit of consumers and a healthy economy with 
robust private insurance markets. We are optimistic that with high 
level political appreciation for the role that insurers play in the 
global economy, policies can be developed that begin a virtuous cycle 
of growth and stability.
Solvency II and the U.S.-EU Regulatory Dialogue Project
    The core intent of Solvency II was and is to improve the prudential 
regulation of the European Common Market in insurance. As we recognize 
that Solvency II is an internal European undertaking, we have been 
engaged on ``third country'' provisions, which are intended to extend 
the benefits of unilateral recognition to insurers and reinsurers that 
conduct business into and out of the EU but are headquartered 
elsewhere.
    We have strongly advocated that the U.S. regulatory regime is 
equivalent in outcome to Solvency II and that this should be recognized 
by the European Commission. We are pleased that there has been a 
productive process established between the U.S. Federal and State 
Governments and the European Commission and the European Member State 
regulators through their statutory consultative body the European 
Insurance and Occupational Pension Authority (EIOPA).
    This process, called the U.S.-EU Regulatory Dialogue Project, is in 
its fourth year of a detailed information exchange intended to build 
greater transatlantic understanding between regulators of the different 
U.S. and EU approaches to achieving the same regulatory outcomes of 
stability, consumer protection and fair competition. In our opinion, 
this regulatory confidence building has been a tremendous success in 
removing misunderstanding and paving the way for the United States to 
be deemed either transitionally or permanently equivalent by the 
European Union.
    This positive progress however is not a foregone conclusion and the 
Dialogue Project process requires continued work by all sides. We 
believe that the maintenance of a positive relationship between the 
world's two largest markets is simply too important to be disrupted by 
perceived differences in regulatory approach. We also commend the State 
supervisors and FIO for the time and effort they have made to patiently 
explain the U.S. system and to address potential misperceptions.
    The U.S.-EU Dialogue Project has had the ancillary benefit of 
bringing together U.S. and EU regulators within the IAIS decisionmaking 
process. We urge this continued expansion of coordination between U.S. 
and EU regulators within the IAIS to support markets where all 
competitors are held to the same high standards of solvency, market 
conduct and consumer protection.
The FSOC Designation Process
    While FSOC has made improvements to its designation process, we 
believe additional reforms are necessary to enhance transparency and 
ensure a fairer overall designation and de-designation process. Our 
suggestions for improvement focus on the following: providing better 
and more transparent procedural safeguards; affording greater weight to 
the views of an insurer's primary financial regulator; implementing an 
``activities-based approach'' for evaluating the systemic importance of 
insurers; putting in place a viable process for de-designation; and 
promulgating the regulations required by Section 170 of the Dodd-Frank 
Act.
Improve Procedural Safeguards
    One of the most important improvements to the FSOC designation 
process would be to require that a company under consideration be 
provided with access to the entire FSOC record.
    A company that advances to the third and final stage of review has 
no way of knowing what materials FSOC believes are relevant, whether 
and in what form the materials it submits are provided to voting 
members of FSOC, or what materials, in addition to those submitted by 
the company, FSOC staff and voting members reviewed and relied upon. In 
other words, a company is not provided with the evidentiary record upon 
which the voting members will make a proposed or final determination.
    In addition, FSOC should have separate staff assigned to its 
enforcement and adjudicative functions. Council staff who identify and 
analyze a company's suitability for designation and author the notice 
of proposed determination and final determination should not also 
advise Council members in deciding whether to adopt the notice of 
proposed determination and final determination. Dividing Council staff 
between enforcement and adjudicative functions would protect the 
independence of both functions. Communications between Council members 
and enforcement staff should also be memorialized as part of the agency 
record and provided to companies under consideration for designation.
    For an insurer, we believe an essential part of the designation 
process must be to afford special weight to the views of the FSOC 
member with insurance expertise. FSOC must vote, by two-thirds of the 
voting members then serving including the affirmative vote of the 
Chairperson, to issue a final determination. The requirement for a 
supermajority vote is intended to ensure that designation is reserved 
for companies that pose the most obvious risk to the financial 
stability of the United States. Yet, the members of FSOC vote as 
individuals rather than as representatives of their agencies. Thus, the 
vote is based upon their own assessment of risks in the financial 
system rather than the assessment of their respective agencies. 
Moreover, the voting process gives equal weight to views of all 
members, regardless of a member's experience in regulating the type of 
company being considered for designation. In the case of a company 
primarily engaged in the business of insurance, special weight should 
be given to the views of the Council member with insurance experience.
    Upon receipt of a final designation, a company may seek judicial 
review before a Federal court. Even this safeguard, however, is subject 
to limitations. A company has only 30 days in which to file a 
complaint, and loses the right to do so beyond that date. We believe 
that timeframe should be extended. Moreover, filing the complaint 
should carry an automatic stay of supervision by the Federal Reserve 
Board. While a company is challenging the legitimacy of a designation, 
it should not be forced to simultaneously establish a comprehensive 
infrastructure (e.g., systems, procedures, and controls) to comply with 
Board supervision.
    Finally, from a procedural standpoint, we believe FSOC should be 
prevented from misapplying the ``material financial distress'' standard 
for designation. With respect to insurers, it seems clear that FSOC 
assumed the existence of material financial distress at a company and 
then concluded that such distress could be transmitted to the broader 
financial system. Under a material financial distress standard that 
actually meets the statutory requirements of the Dodd-Frank Act, FSOC 
would need to employ the 11 statutory factors to first determine 
whether the company is vulnerable to material financial distress based 
upon its company-specific risk profile and, if it is, then determine 
whether the company's failure could threaten the financial stability of 
the United States. FSOC should not be able to designate a company on an 
assumption it is failing, but instead should designate a company only 
when a company's specific risk profile--including its leverage, 
liquidity, risk and maturity alignment, and existing regulatory 
scrutiny--reasonably support the expectations that the company is 
vulnerable to financial distress, and then that its distress could 
threaten the financial stability of the United States. The purpose of 
designations should be to regulate nonbanking firms that are engaged in 
risky activities that realistically ``could'' cause the failure of the 
firm, not to regulate firms that are not likely to fail.
Afford Greater Weight to the Views of an Insurer's Primary Financial 
        Regulator
    In drafting the Dodd-Frank Act, Congress recognized that many 
nonbank financial companies are subject to supervision and regulation 
by other financial regulators. Insurance companies, for example, are 
subject to comprehensive regulation and supervision by State insurance 
authorities. Thus, Congress directed FSOC to consult with other primary 
regulators when making a designation determination, and required FSOC 
to consider ``the degree'' to which a company is already regulated by 
another financial regulator. Congress also gave the Federal Reserve 
Board authority to exempt certain classes or categories of nonbank 
financial companies from supervision by the Board, and directed the 
Board to take actions that avoid imposing ``duplicative'' regulatory 
requirements on designated nonbank companies.
    FSOC's designation of insurance companies shows little deference to 
these requirements. In the case of MetLife, for example, FSOC 
discounted State insurance regulation even after the Superintendent of 
the New York State Department of Financial Services (NYDFS), Benjamin 
Lawsky, told FSOC that: (1) MetLife does not engage in nontraditional, 
noninsurance activities that create any appreciable systemic risk; (2) 
MetLife is already closely and carefully regulated by NYDFS and other 
regulators; and (3) in the event that MetLife or one or more of its 
insurance subsidiaries were to fail, NYDFS and other regulators would 
be able to ensure an orderly resolution. Similarly, in his dissent in 
the Prudential case, the Council member with insurance experience noted 
that the scenarios used in the analysis of Prudential were 
``antithetical'' to the insurance regulatory environment and the State 
insurance company resolution and guaranty fund systems, and all three 
of Prudential's primary State insurance regulators submitted statements 
rebutting any argument that Prudential could cause systemic risk.
    This lack of deference to an insurer's primary financial regulator 
is particularly troubling given the fact that insurance, unlike every 
other segment of the financial service industry, does not have any of 
its primary regulators as voting members of FSOC. Moreover, none of the 
primary regulators of the three insurers that have been designated were 
``at the table'' when FSOC designation decisions were made.
Implement an ``Activities-Based'' Approach for Insurance
    The Dodd-Frank Act gives FSOC two principal powers to address 
systemic risk. One power is the authority to designate nonbank 
financial companies for supervision by the Federal Reserve Board. The 
other power is an ``activities-based'' authority to recommend more 
stringent regulation of specific financial activities and practices 
that could pose systemic risks. FSOC has not been consistent in its 
exercise of these powers. In the case of the insurance industry, FSOC 
has actively used its power to designate. In the case of the asset 
management industry, FSOC has undertaken an analysis of the industry so 
it can consider the application of more stringent regulation for 
certain activities or practices of asset managers, and it has not 
designated any asset management firm to date.
    FSOC held a public conference on the asset management industry in 
order to hear directly from the asset management industry and other 
stakeholders, including academics and public interest groups, on the 
industry and its activities.
    Furthermore, following its meeting on July 31, 2014, FSOC issued a 
``readout'' stating that FSOC had directed its staff ``to undertake a 
more focused analysis of industry-wide products and activities to 
assess potential risks associated with the asset management industry.''
    In contrast, FSOC has not held any public forum at which 
stakeholders could discuss the insurance industry and its activities. 
Instead, FSOC has used its power to designate three insurance companies 
for supervision by the Federal Reserve Board.
    ACLI and AIA support the more reasoned approach that FSOC has taken 
in connection with the asset management industry and believes that FSOC 
should be required to use its power to recommend regulation of the 
specific activities of a potential designee before making a designation 
decision with respect to that company.
    FSOC's power to recommend more stringent regulation of specific 
activities and practices has distinctive public policy advantages over 
its power to designate individual companies for supervision by the 
Federal Reserve Board. FSOC's power to recommend primary regulator 
action brings real focus to the specific activities that may involve 
potential systemic risk and avoids the competitive harm that an 
individual company may face following designation. As noted above, in 
certain markets, such as insurance, designated companies can be placed 
at a competitive disadvantage to nondesignated companies because of 
different regulatory requirements. Finally, the power to recommend 
avoids the ``too-big-to-fail'' stigma that some have associated with 
designations.
    FSOC's recommendations for more stringent regulation of certain 
activities and practices must be made to ``primary financial regulatory 
agencies.'' These agencies are defined in the Dodd-Frank Act to include 
the SEC for securities firms, the CFTC for commodity firms, and State 
insurance commissioners for insurance companies. A recommendation made 
by FSOC is not binding on such agencies, but the Dodd-Frank Act 
includes a ``name and shame'' provision that encourages the adoption of 
a recommendation. That provision requires an agency to notify FSOC 
within 90 days if it does not intend to follow the recommendation, and 
FSOC is required to report to Congress on the status of each 
recommendation.
Permit Companies to Petition for a Designation Review Based on a Change 
        in Operations or Regulation
    FSOC is required to review the designation of a company on an 
annual basis. A company also should have the opportunity to petition 
for a review based upon a change in its operations, such as the 
divestiture of certain business lines, or a change in regulation. 
Moreover, during a review, FSOC should be required to provide a company 
with an analysis of the factors that would lead FSOC to de-designate a 
company. This would lead a company to know precisely what changes in 
its operations or activities are needed to eliminate any potential for 
the company to pose a threat to the financial stability of the United 
States.
Promulgate the regulations required by Section 170 of the Dodd-Frank 
        Act
    Section 170 of the Dodd-Frank Act directs the Federal Reserve 
Board, in consultation with FSOC, to issue regulations exempting 
certain classes or categories of companies from supervision by the 
Federal Reserve Board. However, to date no such regulations have been 
issued. This requirement represents yet another tool Congress created 
to delineate between those entities that pose systemic risk and those 
that do not. How such regulations might affect insurance companies, if 
at all, is unknown. But presumably the regulations will shed additional 
light on what metrics, standards or criteria operate to categorize a 
company as nonsystemic. The primary goal here should be to clearly 
inform companies of how to conduct their business and structure their 
operations in such a way as to be nonsystemic. Only if that primary 
goal cannot be met should the focus turn to regulating systemic 
enterprises.
Conclusion
    The insurance industry strongly supports full implementation of the 
Insurance Capital Standards Clarification Act. In addition, the 
insurance industry supports a formal rulemaking process with notice and 
public comment for the development of insurance capital standards to 
ensure that the Federal Reserve Board has the best information and 
input from public stakeholders. The goal of this process should be the 
development of capital standards that are specifically designed and 
tailored for the insurance business model. Furthermore, this domestic 
process should not be condensed, abridged, or confused by IAIS standard 
setting. Because the IAIS would benefit from the work of the Federal 
Reserve Board, and because the U.S. position is certain to be informed 
by that work, the IAIS timeline for the development of the ICS must 
accommodate the U.S. process. This sequencing is essential to good 
market and regulatory outcomes for U.S. companies and consumers, and 
also for a healthy outcome to the international discussion.
    The insurance industry also supports reform of the FSOC process, 
including improved procedures for de-designation and increased 
consideration of the views of primary insurance regulators. These 
reforms would strengthen the FSOC and its regulatory goals of 
identifying and diminishing systemic risk.
    Chairman Crapo, Ranking Member Warner, thank you for the 
opportunity to testify before the Subcommittee today.


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


                 PREPARED STATEMENT OF DANIEL SCHWARCZ
        Professor and Solly Robins Distinguished Research Fellow
                   University of Minnesota Law School
                             April 30, 2015
    Chairman Crapo, Ranking Member Warner, and Members of the 
Subcommittee, thank you very much for this opportunity to discuss the 
Financial Stability Oversight Council's (``FSOC'') process for 
designating nonbank financial companies as systemically significant 
institutions. In my testimony today, I plan to make two central points 
regarding this process and its consequences for companies that are 
engaged primarily in the business of insurance.
    First, I will emphasize that the Dodd-Frank Wall Street Reform and 
Consumer Protection Act (``Dodd-Frank'') constructed FSOC's designation 
process to be flexible and adaptive because systemic risk is itself 
complicated and evolving. Although this design choice inevitably 
reduces transparency, FSOC has done a reasonably good job of addressing 
this concern. For instance, FSOC's development of a quantitative screen 
in the first stage of its designation process helps assure the vast 
majority of nonbank financial institutions that they will not be deemed 
systemically significant. At the same time, FSOC's refusal to rely 
exclusively on quantitative metrics in its designation process or to 
define a simple, formulaic ``off-ramp'' for designated firms preserves 
its ability to effectively evaluate and monitor the potential systemic 
importance of individual firms.
    After addressing the transparency of FSOC's designation process, I 
will turn to the consequences of a systemic risk designation for 
nonbank financial companies that are principally engaged in insurance 
(``Insurance SIFIs''). Perhaps the most important such consequence is 
that Insurance SIFIs--in addition to Insurance Savings and Loan Holding 
Companies \1\--will be subject to consolidated capital rules to be 
crafted by the Board of Governors of the Federal Reserve System 
(``Fed''). I will suggest that these rules should focus on the 
potential ways in which the States' Risk-Based Capital (``RBC'') regime 
fails to fully account for systemic risk concerns. In particular, the 
consolidated capital regime should use as its starting point firms' 
consolidated balance sheets, rely on market-based valuations of firms' 
assets, and generally avoid reliance on firms' internal models in 
setting capital or reserve requirements.
---------------------------------------------------------------------------
    \1\ Nothing in Dodd-Frank compels the Fed to use the same capital 
regime for Insurance SIFIs and Insurance Savings and Loan Holding 
Companies. However, many seem to anticipate that the Fed will design a 
single capital regime for both entities, and then apply a capital 
surcharge to Insurance SIFIs.
---------------------------------------------------------------------------
(1) Transparency in FSOC's Designation Process
    One of the central goals of Dodd-Frank is to limit the risk that 
individual companies can pose to the general economy in times of 
financial market turbulence. As exemplified by the substantial role of 
American International Group (``AIG'') in the 2008 Global Financial 
Crisis, the historical assumption that such systemic risk is cabined to 
banks and their holding companies is inaccurate in today's financial 
world. Instead, firms engaging in a wide variety of financial 
activities can, in certain circumstances, contribute to the fragility 
of the financial system in times of general market stress.
    To address this reality, Dodd-Frank empowered FSOC to designate 
nonbank financial firms as entities that could pose a threat to U.S. 
financial stability. Rather than requiring FSOC to use specific 
activity-based or quantitative thresholds in executing this 
responsibility, Dodd-Frank instructed FSOC to consider 10 broad 
factors. Tellingly, Dodd Frank also authorized FSOC to consider ``any 
other risk-related factors that the Council deems appropriate.''\2\ 
Dodd-Frank thus tasked FSOC--a council of the Nation's leading 
financial regulators--with employing a broad and evolving approach to 
identifying systemically significant nonbank financial institutions.
---------------------------------------------------------------------------
    \2\ Dodd-Frank  113(a).
---------------------------------------------------------------------------
    This flexible approach to identifying systemically significant 
nonbank financial institutions reflects a key lesson of the financial 
crisis: that systemic risk can arise in new and distinctive guises due 
to the massive complexity and interconnections that have evolved, and 
continue to evolve, within our financial system.\3\ Just as the errant 
assumption that only banks could create systemic risk was substantially 
responsible for the 2008 global financial crisis, any specific 
quantitative or activity-based definition of systemically significant 
nonbank financial institutions in Dodd-Frank would undoubtedly have 
been under-inclusive. This, in turn, would have incentivized financial 
firms to take on risks that were not captured by the applicable 
statutory definition but where extreme losses could have been 
externalized on to the broader financial system and the general public.
---------------------------------------------------------------------------
    \3\ See generally Daniel Schwarcz & Steven Schwarcz, Regulating 
Systemic Risk in Insurance, 81 U. Chi. L. Rev. 1569 (2014).
---------------------------------------------------------------------------
    As with all broad legal standards, the flexibility of the FSOC 
designation scheme as established in Dodd-Frank inevitably creates 
potential concerns regarding its transparency. Any legal standard that 
relies on expert decisionmakers to apply a broad multifactor test will 
necessarily sacrifice predictability and transparency in favor of 
flexibility and adaptability. This is particularly true in a domain 
such as systemic risk, which is highly technical, constantly evolving, 
and not fully understood by the academic or regulatory communities.
    To help address these inevitable transparency concerns, FSOC 
engaged in a prolonged process of rulemaking to more specifically 
describe its criteria for determining which nonbank financial firms 
might pose systemic risks to the financial system.\4\ FSOC's Final Rule 
and Interpretive Guidance defined three potential ``channels''\5\ 
through which a nonbank financial firm might transmit systemic risk and 
established a six-part analytical framework \6\ to guide its assessment 
of individual firms. At the same time, FSOC specifically declined 
commentators' requests to establish a simple formula that would link 
the transmission channels to the analytical framework or that would 
determine how the six-factor analytical framework would be weighted in 
a final determination. Such an approach, FSOC noted, would be 
inconsistent with the qualitative nature of many of Dodd-Frank's 
statutory considerations and with robust assessment of individual 
financial firms' unique risk profiles.
---------------------------------------------------------------------------
    \4\ See 77 Fed. Reg. 21,637 (Apr. 11, 2012). FSOC issued an advance 
notice of proposed rulemaking in 2010, a first notice of proposed 
rulemaking in early 2011, a second notice of proposed rulemaking in 
late 2011, and a Final Rule and Interpretive Guidance in 2012.
    \5\ These are (i) direct exposure of other firms to the systemic 
firm, (ii) abrupt liquidation of the systemic firm's assets, and (iii) 
the disruption of a critical function or service provided by the 
systemic firm.
    \6\ This framework focuses on (i) size, (ii) interconnectedness, 
(iii) substitutability, (iv) leverage, (v) liquidity risk and maturity 
mismatch, and (vi) existing regulatory scrutiny.
---------------------------------------------------------------------------
    Nonetheless cognizant of continuing transparency concerns, FSOC did 
develop a formulaic quantitative test to screen out only a small subset 
of all nonbank financial firms for potential systemic risk designation. 
Under this screen (which occurs at ``stage one'' of FSOC's designation 
process), firms are generally identified for more searching 
quantitative and qualitative assessment by FSOC \7\ if their total 
consolidated assets surpass $50 billion and they satisfy one of five 
additional quantitative standards.\8\ The effect of this quantitative 
screen is to provide substantial certainty to the vast majority of 
nonbank financial institutions that they will not be designated as 
systemically significant institutions.\9\ At the same time, this 
approach appropriately reflects the reality--illustrated by the crisis 
and embedded within Dodd-Frank--that the potential for a firm to pose a 
systemic risk to the larger financial system cannot currently ``be 
reduced to a formula.''\10\
---------------------------------------------------------------------------
    \7\ The final rule established two post-screen stages of review. In 
the first (i.e., ``stage two''), the Council considers a broad range of 
quantitative and qualitative information that is available through 
existing public and regulatory sources. As originally described in the 
final rule, firms being reviewed during this stage would not be 
notified of this fact. In the final evaluation stage (i.e., ``stage 
three''), firms that FSOC continued to believe could pose a systemic 
risk would be subject to a more detailed review in which they would be 
invited to submit relevant materials.
    \8\ These quantitative metrics ``represent the framework categories 
that are more readily quantified: size, interconnectedness, leverage, 
and liquidity risk and maturity mismatch.'' Id. at 21,642.
    \9\ FSOC did reserve its discretion to evaluate a financial firm as 
posing potential systemic risks even if it was screened out in Stage 
One.
    \10\ Id.
---------------------------------------------------------------------------
    In recent months, FSOC has responded to continued concerns 
regarding the transparency of its process by adopting additional 
reforms suggested by various stakeholders. Among other things, these 
reforms will inform firms earlier in FSOC's process if they are being 
considered for designation and will allow those firms to submit 
relevant information to the Council at that point. It will also provide 
firms that have been designated as systemically significant with an 
enhanced opportunity to participate in the Council's annual 
reevaluation of that designation.
    To be sure, none of this is to suggest that FSOC could not further 
improve the transparency of its operations. In particular, FSOC's 
public basis for designating nonbank financial firms as SIFIs could 
more clearly articulate the relative importance of the identified 
factors in explaining the Council's reasoning.\11\ Additionally, FSOC 
could more clearly develop a process for allowing a SIFI to seek the 
Council's opinion regarding whether specific transactions or 
alterations to the firm's risk profile would allow it to shed its 
designation as a SIFI.
---------------------------------------------------------------------------
    \11\ Government Accountability Office, Financial Stability 
Oversight Council, Further Actions Could Improve the Nonbank 
Designation Process (Nov. 2014).
---------------------------------------------------------------------------
    Nonetheless, in my view, FSOC has done a reasonable job of 
promoting the transparency of its designation process given the 
inherently multi-factored and complex nature of its responsibility. It 
has also rightly resisted calls to develop simple rules defining 
systemically risky nonbank financial firms or a formulaic ``off-road'' 
for systemic risk designation. The nature of systemic risk is too 
fluid, complex, and poorly understood to allow for such simple 
formulas. By using clear quantitative metrics only to narrow the field 
of potential systemically risky nonbank financial institutions, while 
promoting greater participation and transparency among stakeholders in 
the post-screen assessment process, FSOC has struck a reasonable 
balance between transparency, on the one hand, and flexibility and 
adaptability, on the other.
(2) Consolidated Capital Rules for Insurance SIFIs
    Under Dodd-Frank, those nonbank financial firms that are deemed 
systemically significant by FSOC are subject to enhanced prudential 
rules and supervision by the Fed. Perhaps the most important element of 
this regime is the application of new risk-based capital standards on a 
consolidated basis, which Dodd-Frank directs the Fed to develop. The 
Insurance Capital Standards Clarification Act of 2014 authorized the 
Fed to tailor these capital standards to the distinctive risks posed by 
insurers, which are different than the risks posed by banks. But, at 
the present time, the Fed has not made clear how precisely it intends 
to use this authority.
    In my view, the Fed should design capital standards for Insurance 
SIFIs that focus on the potential ways in which the policyholder-
protection design of State RBC rules may fail to fully account for 
systemic risk concerns.\12\ As I have emphasized on multiple occasions 
in prior congressional testimony,\13\ the regulatory objectives of any 
risk-based capital regime have important implications for how that 
regime should be constructed. For that reason, capital regimes focused 
on systemic risk can, and should, be designed differently than capital 
regimes focused on policyholder protection.
---------------------------------------------------------------------------
    \12\ 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.''
    \13\ See, e.g., Daniel Schwarcz, Testimony before the Senate 
Subcommittee on Financial Institutions and Consumer Protection 
regarding ``Finding the Right Capital Regulation for Insurers'' (March 
11, 2014); ``Legislative Proposals to Reform Domestic Insurance 
Policy'' (May 20, 2014); Daniel Schwarcz, Testimony before the House 
Subcommittee on Insurance, Housing and Community Opportunity regarding 
``Insurance Oversight and Legislative Proposals'' (Nov. 16, 2011).
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    Given this perspective, I believe that the Fed should consider 
implementing a capital regime for insurance SIFIs that is consistent 
with three broad principles. First, that regime should use as its 
starting point the consolidated balance sheet of the firm.\14\ The 
current State-based RBC regime focuses exclusively on the balance 
sheets of individual insurance entities. Although this regime generally 
works well to promote policyholder protection, it has important 
limitations when it comes to regulating systemic risk.\15\ This is most 
obvious with respect to AIG's use of a noninsurance subsidiary to issue 
Credit Default Swaps prior to the 2008 crisis. But it was also 
importantly illustrated by AIG's use of a complex securities lending 
program to ``transform insurance company assets into residential 
mortgage-backed securities and collateralized debt obligations, 
ultimately losing at least $21 billion and threatening the solvency of 
the life insurance companies.''\16\ More recently, the Daniel Schwarcz, 
Testimony before the House Housing and Insurance Subcommittee regarding 
entity-based focus of the RBC regime has allowed insurance companies to 
utilize complex transactions with ``captive'' affiliates that may 
create systemic risks.\17\
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    \14\ Consistent with the IAIS's proposed approach, this balance 
sheet could then be broken down into three components: insurance, 
banking, and noninsurance financial and material nonfinancial 
activities. See International Association of Insurance Commissioners, 
Basic Capital Requirements for Global Systemically Important Insurers 
(July, 2014).
    \15\ See generally Daniel Schwarcz, A Critical Take on State-Based 
Group Regulation of Insurers, 5 U. Cal. Irv. L. Rev. (forthcoming, 
2015), available at http://ssrn.com/abstract=2593897.
    \16\ Robert L. McDonald & Anna L. Paulson, AIG in Hindsight (April, 
2015), NBER Working Paper No. w21108, available at SSRN: http://
ssrn.com/abstract=2596437.
    \17\ See generally Ralph S. J. Koijen & Motohiro Yogo, Shadow 
Insurance (February 18, 2015), Swiss Finance Institute Research Paper 
No. 14-64, available at http://ssrn.com/abstract=2320921; Federal 
Insurance Office, How to Modernize and Improve the System of Insurance 
Regulation in the United States (2014); New York State Department of 
Financial Services, Shining a Light on Shadow Insurance: A Little-Known 
Loophole That Puts Insurance Policyholders and Taxpayers at Greater 
Risk (June 2013).
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    Second, the Fed should seriously consider designing its capital 
regime for insurance SIFIs to require valuation of assets at market 
rates. Market-based valuations are more relevant than accounting values 
when it comes to systemic risk regulation, because it is precisely in 
times of potential systemic risk transmission that liabilities 
previously perceived to be long-term can become short-term. To the 
extent this occurs, then systemic firms may find themselves compelled 
to sell their assets at prevailing market rates. Market valuation of 
assets is also more consistent with emerging international norms, thus 
tending to promote cross-jurisdictional comparability, which is 
important from a systemic risk perspective. Although market valuation 
does create potential concerns regarding artificial capital 
fluctuations that could possibly contribute to fire-sale dynamics, 
these issues could conceivably be dealt with by adjusting required 
capital levels in times of economic stress.
    Third, the Fed should not allow firms to use their own internal 
models to determine adequate capital levels and it should also proceed 
with caution in accepting State Principles-Based Reserving (PBR) 
reforms that will allow insurers greater freedom to use internal models 
to set their reserves. A central lesson of the 2008 global financial 
crisis is that firms' internal models can often be overly optimistic, 
which should not be surprising given the incentives firms have to 
maintain lower capital levels and increased leverage. Moreover, in many 
cases it is simply not realistic to rely on regulators to police firms' 
internal models due to the complexity of these models and the imbalance 
of resources available to regulators and private firms.\18\
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    \18\ Federal Insurance Office, How to Modernize and Improve the 
System of Insurance Regulation in the United States (2014).
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    These principles are broadly consistent with elements of the group-
wide, consolidated capital requirements for systemically significant 
insurers that are being developed by the International Association of 
Insurance Supervisors (IAIS). Moreover, the IAIS has made substantial 
progress in recent years in crafting and testing the technical features 
of this framework. Of course, the Fed should remain cognizant of this 
country's unique insurance regulatory scheme in determining how the 
IAIS's capital standards should apply to insurance SIFIs in the United 
States. But it should also seriously consider adopting elements of this 
scheme that would provide a more macroprudential perspective than the 
State RBC regime, which focuses on policyholder-protection. For this 
reason, I believe that the Fed should continue to be an active 
participant in the IAIS's development of consolidated capital 
standards, and should draw on these developments in implementing a 
consolidated capital requirement for insurance SIFIs in the United 
States.

 RESPONSE TO WRITTEN QUESTION OF KURT BOCK FROM SENATOR VITTER

Q.1. Mr. Bock, in your statement you stated, ``We have no 
transactional deposits or loans. Despite this minimal banking 
footprint, COUNTRY is now subject to Federal Reserve 
regulation, including detailed discovery questionnaires and 
regular visits by examiners that seek to learn all aspects of 
our business.''
    How much time and resources has your company used to comply 
with these new regulations? Do you believe that this allocation 
of resources has affected the ability of COUNTRY to grow at its 
maximum rate?

A.1. Since the beginning of our regulation under the Federal 
Reserve, COUNTRY Financial has had significantly increased 
administrative burdens on our compliance and regulatory staff. 
For example, 25 percent of COUNTRY's regulatory and compliance 
staff time is now spent communicating with the Federal Reserve 
even though COUNTRY's depository institution is only $30.5 
million in assets--less than 0.2 percent of our holding 
company. In addition, COUNTRY has had to engage both inside and 
outside counsel in interpreting and responding to requests for 
information or interpretation of rules. We have also added 
documentation and reporting requirements, which are in excess 
and duplicative to our current OCC and State regulatory 
requirements.
    While this reallocation of resources has not stopped 
COUNTRY from continuing to grow, the added burden has further 
stretched our risk management and regulatory compliance areas 
and taken senior executive attention away from other important 
strategic areas within the property casualty and financial 
services markets. The overall impact from new regulation has 
been added administrative costs, which the organization has 
largely absorbed within our existing structures, with marginal, 
if any benefit to the policyholder.

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