FROM THE PEOPLE
The Financial Stability Oversight Council 202I Annual Report offers insights
The insurance sector “buries its own” failed companies through a system of
rehabilitation, liquidation, and state guaranty funds.
By Kevin P. Hennosy
If you desire a little light reading.
The Financial Stability Oversight Council (FSOC) of the U.S. Treasury Department (Treasury) published a 2021 Annual Report, which expresses an interesting take on activity in American insurance regulation.
Do not wait for the Audible edition. Download the PDF from the FSOC website.
Three areas that seem of particular interest to the FSOC consist of 1) The National Association of Insurance Commissioners’ (NAIC’s) activities reluctantly associated with financial regulation of insurance groups, 2) the orderly dissolution of failed insurers, and 3) reforms to reinsurance regulation to foster U.S. adherence to international agreements.
After the utter failure of state insurance regulation in the 2008 financial collapse of American International Group (AIG), one would expect the federal government to recall its loaned, limited, and contingent-upon-use jurisdiction over insurance back from the several states.
In the most forgiving terms, the debacle was akin to an exceedingly high pop-up in baseball, where a group of defensive players gather in a circle and watch the ball hit the ground.
But why be nice? The colossus that was AIG grew too big to regulate before it was too big to fail. No government official was willing to say “no” to the behemoth. To borrow a phrase from Hunter S. Thompson, in the presence of AIG government officials had “The Fear.”
After the failure of the firm, only revived by massive infusions of public cash, officials began a finger-pointing game aimed at blaming other financial oversight jurisdictions. No office accepted that they had statutory jurisdiction over the credit default swap (CDS) products.
Never mind that the products transferred the risk of financial loss triggered by loan defaults, the product’s name did not include “insurance,” so state insurance regulators claimed that they had no statutory jurisdiction over the CDS transactions.
It was as if the CDS business happened in some non-jurisdictional “inter-zone” known only to the investment firms that used the “products” to cover-up the madness of their loan operations.
After AIG’s failure, Congress conducted a hearing where one desperate NAIC officer went as far as to testify under oath that the world’s largest insurance company was not really an insurer at all!
In truth, no official wanted to take the punch bowl away from the firm’s Hairy Buffalo party. The officials turned their attention to their knitting like a fraternity house mother during pledge season.
Had any state jurisdiction wanted to exert regulation on any part of AIG they could have tried. If the company fought the regulators’ jurisdiction, the latter could have gone to court.
The failure should have been the end of the pretense of regulation offered by the states-only system. Instead, the Dodd-Frank Wall Street Reform and Consumer Protection Act created the FSOC of the U.S. Treasury to monitor systemic risk to the financial system.
After four years of rest in a proverbial sensory deprivation tank, the FSOC emerged in 2021 to resume its charge: to search for and address systemic risk in the U.S. financial sector.
The annual report presents a discussion of state-based activities, which includes discussion at theNAIC. The FSOC has monitored the NAIC’s efforts to amend its recommended Model Holding Company Systems Act and related model regulation.
“On December 9, 2020, NAIC members adopted revisions to existing holding company model legislation to implement the Group Capital Calculation (GCC) and Liquidity Stress Test (LST),” notes the report. It continues:
The GCC is a group wide capital reporting and assessment framework including insurers, financial, and nonfinancial Council Activities and Regulatory Developments businesses within an insurance group. The LST for large life insurance groups meeting the scoping criteria provides lead state regulators with more insights into the groups’ liquidity risk.
Well, “Virginia,” we can all hope that is the case. When these two projects began, industry and regulatory sources told this writer that the purpose of these two projects was to provide a plausible excuse to eliminate fixed capital and surplus requirements—a full employment act for the actuarial profession that would free-up “dead money” for use in sandboxes of speculative play.
One can certainly hope that the U.S. Treasury is not simply accepting the NAIC’s word on what happens inside these two black boxes. With knowledge of the history noted above, this writer found the following line in the report a tad unnerving: “Until adoption of the legislative revisions, states will use existing examination authority to conduct the stress test.” There is no doubt that the states hold this authority, but the fear is strong in the college of insurance regulation.
Rapid and orderly
So what if, in the author Chinua Achebe’s phrase, “Things Fall Apart”?
The Dodd-Frank Act of 2010 requires the Treasury Department through the FSOC to develop frameworks for rapid and orderly dissolution of failing or failed financial institutions. The FSOC report notes, “Under the framework of the Dodd-Frank Act, resolution under the U.S. bankruptcy code is the statutory first option in the event of the failure of a financial company.”
Of course, the insurance sector is an exception to this rule.
The insurance sector “buries its own” failed companies through a system of rehabilitation, liquidation, and state guaranty funds. Under that system, state agents take control of the failing or failed insurer. The liquidator sells off books of business and other assets to augment the estate’s ability to pay outstanding claims.
The balance of claims receive payment from “guaranty funds” financed through an assessment against healthy insurers. Assessed insurers receive reimbursement from the state through premium tax deductions and the ability to build assessment expenses into rates.
Historically, state officials describe the guaranty fund system as consumer-oriented, as compared to the U.S. bankruptcy code, because only the former pays policyholder claims before general creditors. This difference causes some advocates for reinsurers to pine for the application of bankruptcy law, where reinsurers would be just another general creditor.
Just as many state officials would give up the loaned authority over insurance transferred by the McCarran-Ferguson Act if they knew their state would retain the insurance premium tax as a source of revenue, ulterior motives exist for state officials’ love for retaining jurisdiction over rehabilitations and liquidations.
In New York State, the pre-assessment guaranty fund provides a pool of money under state control, which governors have attempted to use to hide budget deficits.
In most states, the rehabilitation and liquidation authority are powerful forms of patronage. An insurance commissioner or governor naming a rehabilitator or liquidator is analogous to declaring the recipient a person of wealth. In return, the state official can expect fundraising help of various kinds from liquidators of failed firms.
Despite the separate system for the dissolution of failed insurers, the FSOC report cites instances where federal authority still applies “in the event of material financial distress or failure.” Select entities must file “living wills” with federal offices when deemed to present systemic risk.
The FSOC report reminds readers that the Dodd-Frank Act “requires nonbank financial companies designated by the Council for supervision by the Federal Reserve and certain [bank holding companies]—including certain [foreign banks] with U.S. operations—to periodically submit plans to the Federal Reserve, the [Federal Deposit Insurance Corporation] and the [FSOC] for their rapid and orderly resolution under the U.S. bankruptcy code in the event of material financial distress or failure.”
Also highlighted in the report is an effort by U.S. and European officials to foster trade in insurance and reinsurance. According to an October 2020 statement from the Office of the United States Trade Representative (USTR), it is the policy of the United States to secure “the removal of collateral and local presence requirements for reinsurers, on the provisions on group supervision, and on exchange of information.”
The Bilateral Agreement between the U.S. and the European Union (EU) on Prudential Measures Regarding Insurance and Reinsurance [U.S.-EU Covered Agreement], addresses three areas of “prudent” insurance oversight: 1) reinsurance; 2) group supervision; and 3) the exchange of insurance information among supervisors and regulators.
When Great Britain exited the EU, the former signed a similar bilateral agreement with the United States, which became operative on December 31, 2019. Again, citing the USTR statement, U.S. and European officials continue “to encourage relevant authorities to refrain from taking any measures that are inconsistent with any of the provisions” of the agreements.
The FSOC refers to both the EU and UK bilateral agreements as “covered agreements,” in reference to a category of international arrangements recognized by the Dodd-Frank Act. And the FSOC continues to monitor the NAIC’s efforts to reform the insurance regulatory system to foster U.S. adherence to the agreements.
For example, “Throughout 2021, states continued to adopt the NAIC Credit for Reinsurance Model Legislation and Regulation, which modifies state reinsurance rules in light of the U.S.–EU and U.S.–UK Covered Agreements.”
“To facilitate implementation of these models in the states, the NAIC adopted additional changes to the Uniform Application Checklist for Certified Reinsurers and a new Uniform Checklist for Reciprocal Jurisdiction Reinsurers” is a hopeful observation drawn from the FSOC report. The same is true of the report’s reference to the NAIC revisions to its Process for Evaluating Qualified and Reciprocal Jurisdictions.
The FSOC employs a more nuanced understanding of the insurance regulatory system than once was the case. The oversight group should build upon this success and report on how the individual states implement the NAIC’s recommendations. Until that time, one may question the council’s understanding of systemic risk lurking in the insurance sector.
At present, the FSOC Annual Report seems to award too much gravitas to NAIC activity. The NAIC is not a regulatory body, and it is certainly not a “standard setting” organization for any jurisdiction. All NAIC pronouncements are a pretense of regulation—the public policy equivalent of playing with paper dolls.
The NAIC remains a Delaware-chartered corporation that receives no financial or administrative oversight from any jurisdiction. The FSOC should look at the NAIC in only one way: down.
If the FSOC wanted to consult a private company with real power in state legislatures, they should travel beyond the NAIC office in Kansas City, Missouri, and visit Koch Industries in Wichita, Kansas. No, Charles Koch does not believe in regulation, but neither does he deal in pretense.
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate