Filed Under:,

Watch and See How SIFI Changes Everything

A proposal outlining the factors federal regulators want to use in determining whether an insurer is “systemically significant” has launched a period of great uncertainty for the life insurance industry.

The proposal was published for comment Sept. 11 by the Financial Stability Oversight Council.

It sets out the criteria that will be used by the Financial Stability Oversight Council in determining whether a non-bank is SIFI—a systemically important financial institution—under a provision of the Dodd-Frank financial services reform law.

The proposal was first published in January, but it was re-crafted under pressure from the insurance industry and their supporters in Congress.

The industry contended that the initial proposal did not take into account the differences between banks—the primary concern of the FSOC—and non-bank financial providers such as insurers.

Moreover, the industry and its congressional supporters wanted the regulation to be more specific in disclosing the qualitative and quantitative standards that will be used in determining whether an institution is systemically significant.

Howard Mills, chief advisor for the insurance industry group at Deloitte in New York, said a key first step will be the recommendations made to the FSOC by Michael McRaith, director of the Federal Insurance Office, as to which insurers, if any should be designated as SIFI.

“We are very much in a wait-and-see mode as to which insurers he will recommend to be designated as SIFI,” Mills said.

Mills said that the expectation is that McRaith will make such recommendations in the “near future,” but added that there is no deadline under the Dodd-Frank Act as to when he should do so.

At the moment, industry analysts believe that only two life insurers—MetLife and Prudential—will have to justify to the FSOC they do not merit SIFI classification.

But there is widespread acknowledgement that regulation of the life insurance industry—which has been solely in the hands of the states since the nation’s founding—is entering an entirely new phase.

The initial SIFI screening will cover a host of companies, including any non-bank financial services company with $50 billion in global total consolidated assets. This would include large domestic stock and mutual insurers.

Moreover, as pointed out by George M. Williams, a partner at Dewey & LeBoeuf in New York, it also includes foreign insurers with $50 billion in U.S. assets.

Williams also said that the proposed regulation may be of particular importance to financial companies that have not generally been subject to federal regulation, such as many insurers with no affiliated insured depository institution.

For example, he points out that under the Dodd-Frank Act, the Financial Stability Oversight Council and the Federal Reserve Board have back-up examination powers if they consider the examinations conducted by other agencies to be inadequate for purposes relating to systemic importance.

He said that measures that may be indicative of potential distress for some kinds of insurance companies (to take one example) may not be indicative for others.

Another industry lawyer who asked not to be named described the process as one of “reverse engineering” by “first deciding whom they wanted to regulate.”

He said that once a company is established as meeting the first SIFI criteria, “the rest is subjective.”

“They are free to pick and choose who they want to select as SIFIs,” the lawyer argued. He insists that there is “no standard an insurer or other non-bank can hold the FSOC up to legally.”

He argues that it is “totally up to the FSOC to determine if you are a SIFI once you make the initial cutoff.”

The lawyer said the proposal is 63 pages long, “but I have above given you the answer.”

The lawyer, who is advising insurers as well as hedge funds, broker-dealers and others who would come under the SIFI designation, said that there are some significant questions as to whether the whole process is Constitutional, “but since the 1930s there are no Supreme Court cases addressing this broad delegation of authority to any agency.”

Under the law, if an insurer were to be designated as SIFI, it would be regulated by the Federal Reserve Board, which will establish the “prudential standards” the non-bank SIFIs must adhere to. The SIFI would have to register with the Fed within six months and would be subject to additional capital standards as well as other requirements.

Above all else, it ushers in a brave new world of regulation and scrutiny regardless of how many institutions, if any, are cited as SIFI.

Because, as Williams stated, federal authorities have never had the power to examine the books of insurers or impose any other form of scrutiny…until now.

This was imposed on a de facto basis until 1945, when the McCarran-Ferguson Act specifically reserved to the states the authority to regulate the business of insurance.

The Supreme Court clarified this authority when it said oversight of insurers is strictly allotted to the states unless a federal law or rule specifically related to a particular issue.

It was again confirmed in the 1999 Gramm-Leach-Bliley Act, both in a resolution reserving insurance regulation to the states, and, in a provision that specifically stated that the Federal Reserve Board had no authority to regulate insurance holding companies.

Allowing federal intrusion into insurance oversight, albeit on a limited basis, was provided through the 2010 Dodd-Frank financial services law.

The limited intrusion was allowed, however, during the 2008-2009 world financial crisis, when the federal government sought to provide both cash and guarantees to sustain American International Group.

In return for the authority to borrow up to $120 billion in cash from the Treasury and the Federal Reserve, as well as guarantees and other aid, AIG gave the federal government control of 79.9% of its stock.

The government currently owns a greater percentage of AIG stock in exchange for ending direct financial aid to the company.

Other insurance companies also received federal financial aid during the crisis through the Troubled Asset Relief Program, or TARP, including Hartford Insurance Group and the Lincoln Financial.

Under the proposal, non-bank companies that have at least $50 billion in total consolidated assets and meet or exceed any one of the following thresholds will be evaluated as potential SIFIs and therefore subject to oversight by the Fed as well as the current state regulation. The other thresholds are as follows:

  • $30 billion in gross notional credit default swaps outstanding that reference the nonbank financial company’s debt obligations
  • $3.5 billion of derivative exposure liability to third parties
  • $20 billion of outstanding loans borrowed and bonds issued
  • 15-to-1 leverage as measured by total consolidated assets (excluding separate accounts) to total equity
  • 10% ratio of short-term debt (maturity of less than 12 months) to total consolidated assets

In addition, according to a legal alert Oct. 17 by Sutherland, Asbill and Brennan, as a fail-safe device for situations where these simple thresholds may not capture a potentially significant company, the FSOC reserves the right to evaluate nonbank financial companies on other “firm-specific qualitative or quantitative factors, such as substitutability and existing regulatory scrutiny.” The companies identified in Stage 1 (the Stage 2 Pool) would be further assessed in Stage 2.

According to Jeff Schuman of Keefe, Bruyette & Woods, only MetLife and Prudential Life as stock life insurers are likely to be subject to the second and third test as SIFI under the new scrutiny.

Schuman also said the proposed regulation is “good news” for most large life insurers.

Colin Devine, an analyst at Citigroup Global Markets, was more circumspect.

He said that current disclosure makes it difficult to assess who may face Stage 2 testing.

He said that under the Stage 1 tests, MetLife, Prudential, Manulife (which owns John Hancock), Hartford, Aflac, Ameriprise, Genworth, Principal, and Sun Life (which owns asset manager MFS) and Unum all meet the criteria of having at least $50 billion in consolidated global assets.

However, he said, only MetLife and Prudential immediately stand out as exceeding the $20 billion test for outstanding debt.

In addition, he said, “we have not been able to fully determine if Hartford, Lincoln or Manulife, each of which utilizes an extensive hedging program in conjunction with their large variable annuity liability risk management programs, might exceed the $3.5 billion derivative liability test.”

Insurers, Devine said in his investment note, generally only report net derivative values whereas the Stage 1 test is based upon the fair value of any derivative contracts in a negative position after taking into account the effects of master netting agreements and cash collateral held with the same counterparty on a net basis.

Similarly, Devine said, in the case of credit default swaps, the notional amount used in the screening test is based on those for which a nonbank financial company is the reference entity.

“But, it may be the case that when the final regulations are released the evaluation will apply based on CDS [credit default swaps] written on a particular company rather than those purchased or sold by that company,” Devine said.

However, Schuman and Devine only cover stock life insurers.

A number of high-profile, well-capitalized mutual insurers also have more than $50 billion in assets, the primary criteria for initial scrutiny. These include Northwestern Mutual, Guardian Life, Mass Mutual, New York Life Insurance Company and Pacific Mutual.

However, Joel Levine, associate managing director, insurance ratings, said that based on the criteria cited in the proposed regulation, he has considerable doubts as to whether any large mutual life insurer will ultimately be cited as SIFI.

At the same time, Levine said Fitch Ratings regards being cited as SIFI as credit-positive for the insurance company because it would be subject to higher capital standards and enhanced supervision. Put another way: “There is another pair of eyes looking at the books.”

Levine said that “perhaps the most important thing to look at is the biggest question not being answered by the FSOC, or the Fed, which is what will being designated SIFI mean for the companies in terms of enhanced supervision?”

He said the FSOC and Fed officials have not yet figured out the metrics of enhanced supervision, what it will entail, how much additional capital companies will be required to hold, or what will be the measurement of required capital.

Levine said “the regulators have figured this out for banks, but not for non-banks, particularly for insurance companies, which is what I am concerned about.”

He said the federal regulators “don’t have the experience of measuring insurance companies.” For example, he said, Metlife is regulated as a bank holding company.

“When they get tested, they put Met through the same set of tests that they use to measure bank holding companies,” Levine said.

“What tests will be used to evaluate whether an insurer is SIFI remains to be determined—and that is important,” Levine said. “How strict is that evaluation going to be? We don’t know. It is hard to form an opinion.”

As a result, Levine said, it is unclear how a SIFI designation will impact an insurer.

“It is hard to get overly excited about what SIFI criteria means for mutual insurers because we don’t have enough information at the moment,” he said.

Schuman agreed. He said in his investment note that just because MetLife and Prudential meet the threshold criteria, it does not mean they will ultimately be subject to regulation by the Federal Reserve Board as SIFI under the Dodd-Frank Act.

“In our view, life insurers generally do not create high systemic risk in at least several of the categories” cited under the proposed regulation, including substitutability, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny, Schuman said.

“As a result, we think it’s far from certain that MetLife and Prudential will ultimately be designated as SIFIs,” Schuman said.

He explained that it should also be pointed out it is unclear what consequences will attach to a SIFI designation for a non-bank financial.

“In the case of insurers, we would think that the FSOC might show significant deference for the existing insurance regulatory capital framework,” Schuman said.

MetLife falls above the total debt, derivative liabilities, and CDS thresholds, while Prudential falls above the mark on total debt and derivative liabilities.

The FSOC said it believes these thresholds will provide “meaningful initial assessments” regarding the likelihood that a NFC could pose a threat to U.S. financial stability; and that thresholds “add significant transparency to the designation process.”

Joseph Longino, a principal at Sandler O’Neill, a New York-based investment bank that focuses on financial companies, explained that the thinking behind creation of the FSOC was outlined by Daniel K. Tarullo, a Fed board member, in a speech in June.

Longino said the FSOC was created because regulatory regime prior to 2008 was “microprudential” in its focus on individual firms.

The post-crisis regime adds a “macroprudential” focus on systemic risk created by interconnected markets and large players in them, Tarullo said.

“There is universal consensus, even among SIFIs, that there must never be another TARP,” Tarullo said.

He explained that the Basel III capital regime is an important improvement in microprudential focus, but it does not require SIFIs to carry sufficient capital to mitigate systemic risk, and they have no incentive to do so.

Therefore, Tarullo said, the Dodd-Frank Act requirement of enhanced capital for SIFIs is an important complement to its orderly resolution provisions.

A legal challenge waiting to happen

Federal financial regulators are developing a plan to oversee large non-bank financial institutions they deem a potential systemic risk, while fully aware that a court challenge to the SIFI designation is in their future.

“Ultimately, inevitably, there is a going to be a court challenge to a finding that a company is systemically significant,” an industry official who declined to be named for obvious reasons, said.

The Treasury Department, which is managing the Financial Stability Oversight Council because the Treasury secretary is its chairman, “understands that,” the source said.

Moreover, the original proposal was fatally flawed for several reasons, and there is reason to believe the revised proposal could be successfully challenged in court because of the way the rule was constructed, according to one industry official.

This official said one critical flaw still remaining is that the criteria that would be used in deeming an institution SIFI “is still not very clear.”

The official said “there must be a clear definition of what constitutes being systemically significant, and that is a glaring omission.”

The original proposal was published for comment in January; the revised proposal was approved by the FSOC for publication for comment on Sept. 12.

“The original rule didn’t go into specifics,” the source said. “It outlined six general criteria in the preamble that would be used in determining which institutions would be regulated as SIFI, but didn’t include those in the regulation itself.”

The source said the revised rule cured that problem, “improving the final rule’s chances of surviving a court challenge, but the proposed rule as rewritten is still susceptible to being overturned in court.”

Industry officials said the original proposal outlining the criteria that would be used in determining which firms would be regulated as SIFI was so lean on specifics because the federal regulators who make up the FSOC were divided on what criteria they wanted to use in determining which non-banks were systemically significant.

The reason that conflict existed is that some members of the FSOC “didn’t want to box themselves in. They wanted to provide themselves with the greatest flexibility possible in determining who would be regulated as SIFI.”

An insurance industry official said the industry was unanimous in opposing the original proposal because it was not specific enough as to the criteria that would be used—and “it doesn’t look as if the revised proposal reflects the fact that insurers are fundamentally very different than banks.”

Five of the largest life insurers wrote a letter to the FSOC outlining their concerns about the original rule, but continued efforts by National Underwriter to obtain the letter have been unsuccessful.

All you wanted to know about SIFI

  • The following summarizes the process for determining whether a non-bank such as a life insurer should be cited as “systemically significant,” and the general factors the Financial Stability Oversight Council will use in regulating a SIFI.
  • FSOC will determine if a company is a SIFI on a case-by-case basis
  • Requires 2/3rds vote of the Council
  • Two grounds for finding that a company is a SIFI: 1) a material financial distress at the company could pose a threat to U.S. financial stability; or 2) the nature, scope, size, scale, concentration, interconnectedness, or mix of activities could pose a threat to U.S. financial stability
  • The Council may request the Fed to examine any U.S. financial company, and the Fed is authorized to conduct such an exam
  • The Council will consider all 10 statutory factors when making its decision
  • The Council may require that the financial activities of any company be supervised by the Fed if the Council finds that such activities pose a threat to U.S. financial stability
  • Council may request submission of data from the Office of Financial Research and member agencies, as well as other State and Federal agencies, as the Council deems necessary
  • The Council may direct the Office of Financial Research to obtain data and reports from any nonbank financial company
  • Council shall maintain the confidentiality of any data submitted pursuant to these provisions
  • Companies shall be provided notice and have an opportunity for a written or oral hearing in connection with a SIFI designation. This would be an informal hearing with no right to cross examine witnesses
  • In an “emergency” the Council can waive due process procedures, but the company will have the opportunity for an after-the-fact informal hearing

 

Top Sales and Marketing Ideas - 2014

Special Feature

2014 100 Best Sales & Marketing Ideas

There are a million ways to sell an insurance product, and any one of them may work depending on your target market, your product lineup and your own unique skill set.

Explore Now
More Resources

Comments

Close

Advertisement. Closing in 15 seconds.