Tangled up in Pru

FSOC members may not have started with a "different point of view," but ended with one

Bigger is not better, according to Fed analysis of insurers (AP Photo/Douglas C. Pizac) Bigger is not better, according to Fed analysis of insurers (AP Photo/Douglas C. Pizac)

Domestic insurers and reinsurers other than Prudential Financial could face consolidated regulation by the Federal Reserve Board, judging from the Sept. 19 majority opinion of the Financial Stability Oversight Council (FSOC) on the SIFI-designated insurer, although members would be quick to point out under the Dodd-Frank Act (DFA) that each case is judged upon its merits and will not create any spillover effect.

However, others point out that the sheer size of Prudential, and its interconnectedness, rather than its activities, are part of the basis for the FSOC's 7-2 vote that the Newark, N.J.-based behemoth is a systemically important financial institution (SIFI).  

This rationale of looking at the totality of the enterprise tees up other large insurance firms for similar scrutiny, from Berkshire Hathaway with its huge insurance holdings to private equity firms gaining control of annuity providers to even the large mutual life insurers. It depends if the company is judged to have 85 percent of its annual gross revenues or 85 percent of its total consolidated assets derived from activities that are financial in nature, as required for SIFI consideration under the DFA.

The Premise

Under the statutory standard, the Council assumes material financial distress in its analysis of Prudential--or any company it reviews for SiFI status--as a starting point. It is supposed to look at the company as if facing material financial distress. The majority did so, outlining a now controversial scenario in which most -- if not all -- policyholders were trying to surrender, withdraw or otherwise cash in their policies and pensions from Prudential’s hundreds of subsidiaries. The FSOC majority only then looked at the impact to the broader economy and found it shaken. Read the Basis here

The cataclysm is envisioned to happen by forced asset liquidations, which would topple asset values at other life insurers, leading to reputational ruin of the sector, asset fire sales and a general loss of confidence in similar  financial institutions, culminating in instability within the economy as a whole.

As one dissenter noted, “I believe that, absent a catastrophic mortality event (which would affect the entire sector and also the whole economy), such a corporate cataclysm could not and would not occur.”

But even financial firms that have small exposure to a variety of firms but large exposure in the aggregate, as Prudential was characterized by the FSOC, have gotten into trouble and caused ripples throughout the broader economy, which has some federal officials worried that if they did nothing, a larger-scale event involving Prudential would shake the economy.

While “individual exposures to Prudential may be small relative to the capital of its individual counter-parties. In the aggregate, however, the exposures across multiple markets and financial products are significant enough that material financial distress at Prudential could aggravate losses to large, leveraged financial firms, which could contribute to a material impairment in the functioning of key financial markets or the provision of financial services by Prudential’s counter-parties,” the FSOC majority wrote, noting derivatives exposure in particular. 

“For example, if Prudential were to experience material financial distress, the company’s derivatives portfolio could be a source of risk to its derivative counter-parties, which could experience losses through unwinding bilateral derivative trades. The largest of Prudential’s derivative counterparties also have other significant exposures to Prudential,” FSOC pointed out. 

Discordant views at the Council

Not all agree and the vote, viewed as inevitable by many, was hard won among those who did or would have dissented, including independent insurance expert Roy Woodall, the Acting Director of the Federal Housing Finance Agency Ed DeMarco and nonvoting member John Huff, the National Association of Insurance Commissioners’ (NAIC) representative, also Missouri insurance director. 

Read the dissents here.

“The underlying analysis utilizes scenarios that are antithetical to a fundamental and seasoned understanding of the business of insurance, the insurance regulatory environment, and the state insurance company resolution and guaranty fund systems,” Woodall stated.

The robustness of the state insurance regulatory system, guaranty funds and all, came up short in the analysis by FSOC and the insurance parties called out the majority for giving the state system short shrift. The “existing regulatory scrutiny” is a factor in the analysis for the proposed SIFI designations. 

Dissenters, also, among other concerns see the designated insurers as never being able to shed the SIFI skin once they are sheathed in it -- that the Federal Reserve Board has no intention of letting go. That’s because the basis for the SIFI designation by the majority does not address any activities the insurer could limit or exit, but more its overall profile.

Who's Next? 

Using the same rationale, other large life insurers such as MetLife, already in stage three of SIFI review, and a number of other life insurers over the $50 billion in assets threshold could be viewed as potential SIFIs. These include the large mutual life insurers and MidAtlantic or Midwestern players. 

However, MetLife and Prudential dwarf by total assets the next largest U.S. life insurer, Lincoln National. Berkshire Hathaway is huge, with Geico and General Re but as FSOC nonvoting member Michael McRaith, director of the Federal Insurance Office (FIO), pointed out in House testimony in May 2012, “When a traditional insurance business fails, not every car owner is going to get into a car accident immediately upon dissolving ... there is not the same prospect of a run.”

Some argue that the fate of Prudential was sealed when it, with MetLife and AIG, were voted as global systemically important insurers (G-SIIs) by the Financial Stability Board (FSB) as announced July 18. This means that their "national regulator" would need to develop certain capital and oversight standards and restrictions for them. Some argue this would have to be the Federal Reserve, or Treasury, under Dodd-Frank, as a “national authority” who “apparently assented to the FSB designation of Prudential as a G-SII -- even prior to Prudential’s evidentiary hearing before the Council,” Woodall wrote.

McRaith said in the May 2012 testimony that FIO was working with the IAIS on the “criteria, methodology and timing” of SIFI designations “so no U.S. insurer is disadvantaged through global designation of [SIFIs].”

Troubled international waters 

“Although not binding on the Council’s decision, the declaration of Prudential as a G-SII by the FSB based on the assessment by the U.S. and global insurance regulators, supervisors, and others who are members of the [International Association of Insurance Supervisors (IAIS) has overtaken the Council’s own determination process.” Woodall asserted.

Woodall, as he has pointed out in dissent and Congressional testimony, is an insurance voting member of FSOC yet is not admitted under a fall 2012 proposed change in by-laws to the Basel-based IAIS membership body, and feels thwarted. Woodall said he is not “privy” to the secret deliberations of the IAIS -- as members of the the NAIC, FIO and World Bank are, and voiced suspicion at the FSB designations and their possible bearing on the SIFI process domestically. Some international insurance supervisors would also want to bring more people to the table at the IAIS meetings if by-laws are changed for U.S. stability personnel so some see a change in by-laws as opening the floodgates to more foreign banking supervisory types.

However, this view of FSOC paying homage to an international designation has also been countered as "poorly informed" and "tremendously disrespectful" of the FSOC process to study with great rigor the company before it on its own. 

With such troubles gaining steam through the summer, and amid vigorous discussion, voting delays and tensions at the Council, more than the required two-thirds of voting FSOC members finally conceded to the Administration’s stance, as broadly voiced by Treasury Sec. Jacob Lew, chair of the FSO, in statements this month.

Woodall, in a lengthy, sharp-tongued and multi-faceted dissent, called the failure hypothesis implausible based on “misplaced assumptions” of a large scale runs on the company at all levels in all accounts, and without giving enough weight to mitigating interventions built into the system. 

The majority view is that these measures would cause further alarm among policyholders and then the general public. And the last thing the country wants is a riot in the streets for cash. 

Could it happen here?

But the “reliance on the lack of a precedent for a failure of an insurance company the size and scale of Prudential begs the question of why there has been no such precedent? It seems inherently unreasonable to make negative inferences about the current state resolution and guaranty systems based on the lack of such precedent, while presuming material financial distress and the failure across all insurance subsidiaries; without a reasonable and complete assessment of the extremely low probability of such a scenario occurring,” Woodall stated in his dissent.

And if there is concern, although unsupported, according to DeMarco, for a run-risk as a key catalyst for a destructive asset liquidation, with spillover into the greater economy and a state system unable to handle such an event, then the Council could instead address those concerns  with other tools, he wrote in his dissent.

Huff agreed with DeMarco and criticized the majority for an overall failure of analysis that does not take into account the very nature of insurance products and insurance consumers but instead treats scenarios as if banking is the business analyzed. Huff also says that the majority also does not adequately analyze actions taken by Prudential’s counterparties, which include several of the largest U.S. banks, or their regulators, to manage the risks arising from transactions with Prudential or other financial counterparties. 

AIG was unanimously designated a SIFI by the FSOC June 3rd and took its designation and accepted it by July, unlike Prudential, which forced the appeal showdown and is still weighing its options to pursue the matter in court. Although a shorthand version of the Prudential rationale was used for AIG’s life business, AIG has property casualty, seen as less systemically risky, and non insurance operations, seen as more risky, but its designation did not provoke an outcry from the company or other FSOC members. Prudential is also a larger life insurer than AIG.

The only way for any regulator to check everything under the lid of the trunk is through consolidated supervision, and only the Fed can now do this, according to a source. The claims that this can be accomplished at the state level through group supervision and supervisory colleges is limited, and would require a 50-state compact, this person said.

Thus, the Fed wants a window into this and other big companies as it monitors major players in the U.S. economy and is on its way to getting it with this latest action mandating consolidated oversight of Prudential, something the states could not offer. 

Too big to fail, er, understand?

However, dissenters argue that all the majority did was prove that Prudential -- which has over $1.1 trillion in assets under management and is the fifth-largest life insurer in the world with more than $3.5 billion in life insurance in force, according to BestLife -- is a very larger insurance company whose individual exposures would not have a systemic impact.

“In attempting to address the fact that individual exposures would not have a systemic impact, the Basis aggregates exposures and argues that, together, such exposures could pose a threat to the financial system of the United States. In so doing, the basis merely demonstrates that Prudential is a large insurance company,” Huff stated.

There are multiple factors that go into sifting through companies to identify potential SIFIs, and the way the rules are written, size alone is not enough. Exposure, liabilities, interconnectedness, liquidity risk, derivatives activity and many other factors are measured under the SIFI designation rules. 

However, the run on the bank and contagion rationale, anticipated after the AIG rationale on its life insurance exposures, but rejected by the NAIC, the states, the industry in multiple statements and members of the insurance block at FSOC, carried the day. 

"...other insurance companies could be exposed to second-order effects if asset liquidations at Prudential sparked a loss of confidence in the broader insurance industry because of their similar product or balance sheet profiles, potentially leading to policy withdrawals, surrenders, or redemptions at other major insurers. Even if Prudential were able to avoid significant asset liquidations in response to surrender and withdrawal requests by invoking a stay, these requests, once started, could cause market participants to lose confidence in the financial strength of companies with similar product or balance sheet profiles," the majority said, stressing its concern about the message sent to the economy by policyholders, apparently of all ages, health status and investment levels, trying to get their money out of policies - -then being told they couldn't or would have to wait.

NAIC President and Louisiana Insurance Commissioner Jim Donelon stated that he was deeply troubled by the implications of the FSOC’s action designating Prudential as a SIFI. 

“The justification for this designation shows fundamental gaps in FSOC's understanding of the business of insurance or the regulatory regime that governs it. More disturbing is the unknown consequences of such a designation and the potential disruption in the insurance marketplace,” Donelon stated. 

Part of the capital standards the Fed will impose on Prudential include the undeniably strict -- and looming -- Basel III banking standards for capital, liquidity and leverage for SIFIs and institutions with thrifts. Even the Fed has delayed Basel III strictures for insurers, accepting their point that they really aren't crafted for the insurance industry, and all are waiting to see if a Congressional fix for the admittedly airtight language, found in Section 171 of the DFA, will make it through the Senate (S. 1369) and the House (HR 2140). Both chambers have a bill lodged now on development of Basel III for insurers. Sec. 171 requires it to use the same capital standards used in regulating banks to insurance companies that operate thrifts.

In a final rule published July 2, the Fed gave Congress time to act when it provided insurers a respite until 2015 from the Basel III capital regimen.

What would Pru do and is Snoopy next? 

Of course, the FSOC handed Prudential a much more detailed, proprietary-data driven analysis of its rationale, based on the confidential information Prudential supplied in stage three of the SIFI process, but it likely supports the same run-on-the-bank scenario playing out as its premise just as the dissents are likely furnished with more data, as well..

Prudential asked for the appeal of its initial SIFI proposed designation June 3rd, believing it was not systemically risky under the set DFA rules. The appeal occurred July 23. 

Whether Prudential will sue in court -- it has 30 days from the Sept. 19 vote -- is the next question. Most people in insurance circles believe it has a case, but whether the insurer with a reputation for civility and mastery wants to  be seen as trying to throw off the harness of a powerful national regulator in a public arena is another story. 

And MetLife, which had no comment, despite its place in the final stage of SIFI determination by the FSOC, will likely be watching what Pru does carefully -- it is giant domestically and internationally, like Prudential, and has a huge derivatives hedging portfolio for variable annuities, like Prudential. 

MetLife has been busy hawking a Basel III alternative as it prepares for its likely inevitable Federal Reserve oversight (again).

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