Public Policy Analysis & Opinion

The devil is in the details

Insurers argue against heightened regulation through the Dodd-Frank Act

By Kevin P. Hennosy

As the New Year begins, the center of insurance public policy is slowly shifting to Washington as federal agencies implement the Dodd-Frank Act (DFA), also known as, the Wall Street Reform and Consumer Protection Act.

The DFA created the Financial Stability Oversight Council (FSOC) to provide comprehensive monitoring to ensure the stability of the United States financial system. This monitoring function includes "identifying threats to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States financial system."

The Volcker Rule

The Property and Casualty Insurers Association of America (PCI) and the American Council of Life Insurers (ACLI) have urged the FSOC to allow insurers the option to speculate for companies' accounts with policyholder funds and to stand behind hedge funds and private equity funds. Both trade associations argue that insurers, even insurers that are bank affiliates, should be exempt from these new restrictions.

The prohibition from which PCI seeks exemption stems from a 5,000-word provision of the law: The Volcker Rule. The provision is named for former Federal Reserve Chairman Paul Volcker.

The Dodd-Frank Act requires the FSOC to study the Volcker Rule and report on issues related to the rule's implementation before January 22, 2011.

The rule is designed to respond to the casino-like culture that permeated the financial services sector after the repeal of the Glass-Steagall Act in November 1999. After the Great Depression, Congress passed Glass-Steagall to establish risk-based firewalls betwixt banking, securities and insurance. Within eight years of Congressional repeal of those firewalls, America suffered the greatest financial collapse since the Great Depression.

The PCI argues that the Volcker Rule was not enacted to apply to the insurance sector. In a public statement the trade association's leadership opines that "the Volcker Rule specifically excludes state-regulated investments of an insurance company and its regulated insurance affiliates and subsidiaries from the new law to avoid duplicative regulation at the federal level.

"According to the Dodd-Frank Act, the FSOC is directed to study and make recommendations on means to 'appropriately accommodate the business of insurance within an insurance company subject to regulation in accordance with relevant insurance company investment laws, while protecting the safety and soundness of any banking entity with which such insurance company is affiliated and of the United States financial system,' among other matters."

Furthermore, the PCI asserts:

While Congress excluded state-regulated insurance companies and affiliates from the Volcker Rule, stringent consumer and marketplace protection measures remain in place and will continue to be enforced. All insurer investments must continue to comply with existing applicable state insurance investment laws and regulations. Federal banking agencies will still monitor existing state investment laws and regulations to protect the safety and soundness of the nation's financial stability. However, the exemption does not affect an insurer's affiliated banks and non-insurance affiliates, which will be subject to proprietary trading restrictions.

Obviously, the PCI believes that since the states did such a good job regulating for solvency at AIG, we have nothing to fear.

The ACLI also asserts that Congress did not intend to bring insurers under the Volcker Rule. The ACLI argues that the DFA explicitly shields the business of insurance under the general assumption that state officials regulate insurers' activities.

The ACLI comments make a special effort to argue that products supported by separate accounts qualify for this special treatment, which begs consideration of whether that is an accurate interpretation of the DFA. Clearly, the ACLI comments sound worried.

The variable products revolution of the last four decades has resulted in products that reflect the attributes (and risks) associated with securities and certificates of deposit. The variable benefit/investment-oriented products supported through separate accounts have very little to do with traditional life insurance products, which transfer the risk of financial loss arising from the death.

Rather than transferring the risk of loss from insured to insurer, variable products transfer the risk of investment loss to those who purchase a variable contract.

The ACLI comments contain a telling description of the variable product market: "Just as investment activities 'by' an insurance company are permitted, so too should regulators confirm that investments 'in' an insurance company separate account are permitted."

Historically, with the exception of equity held in mutual insurers by policyholders, investments in insurance companies are not treated as the "business of insurance." Equities in or bonds issued by insurance companies fall under the jurisdiction of securities regulators.

The ACLI comments make it very clear that the life insurance sector invests in the instruments and transactions that the Volcker Rule seeks to eliminate: "As part of their ordinary, regulated investment activity, life insurers do invest in hedge and private equity funds."

Allowing the life insurance sector to market securities-by-other-names supported by the high-risk transactions that played a central role in the Panic of 2008 could be seen as fostering or preserving systemic risk.

The ACLI comments attempt to downplay the ability of life insurance products to generate systemic risk, by harkening back to the time of fixed premium/fixed benefit products; however, the national and international significance of separate account products become clear in the comment, "Many insurance companies offer institutional life insurance products that have become important tools in helping institutions manage the rising costs of employee benefits." A failure tied to one or more of these arrangements could easily trigger another Panic.

It would not be unreasonable for the FSOC to consider if it is advisable to apply the Volcker Rule in such a way as to not favor one sector over another, especially if the assumption behind the action is based on the effectiveness of state insurance regulation.

Systemic risk

In addition to the Volcker Rule issue, the Dodd-Frank Act charges the FSOC with developing a system of systemic risk regulation including the identification of "threats to the financial stability of the United States." Once again, lobbyists for the insurance sector argue that there is no foreseeable way that the sector could threaten the stability of the United States financial system.

Comments submitted by the American Insurance Association (AIA) observe that "property-casualty insurers engaged in traditional insurance activities do not pose a systemic threat to U.S. financial stability and do not warrant further consideration for heightened prudential supervision by the Federal Reserve."

Of course, the term "traditional insurance activities" has very little meaning in reality.

It is important to note that American International Group (AIG) stood at the center of the Panic of 2008. At the time of its collapse, the "World's Largest Insurer" played an inexcusable and undeniable role in poisoning the well-being of financial markets through the distribution of Credit Default Swaps (CDS) and Collateralized Debt Obligations. (CDO).

The AIG management engaged in nontraditional insurance activities that resulted in a good, old-fashioned financial panic. State regulators proved unable, or unwilling, to step in and prohibit what AIG management wanted to do. Regulators lied to themselves and others by narrowing their vision into smaller and smaller parts of the company that engaged in "traditional insurance activities." Even after the collapse of AIG, the NAIC delivered the ludicrous comment in Congressional testimony that AIG was not an insurance company.

While some will persist in arguing that the insurance companies within AIG never went broke, that is a specious argument. Had not the Federal Reserve and U.S. Treasury committed billions of dollars to keep the AIG monolith running, all the subsidiaries and affiliates would have failed.

The NAIC might as well have argued that the Titanic was not a "ship."

On systemic risk regulation, ACLI's comments note that the typical activities of a life insurance organization do not present systemic risk to the nation's economy: "FSOC should conclude that life insurance companies engaged primarily in traditional insurance activities are not systemically significant and should not be designated under" DFA.

That said, the ACLI identifies key factors in evaluating a potential systemic threat as (1) the extent and nature of a company's transactions and relationships with other financial companies and (2) the extent to which the company is currently actively regulated.

"Actively regulated" is the operative term. The late Senator Joseph C. O'Mahoney (D-Wyo), who negotiated the McCarran-Ferguson Act, called for "affirmative regulation" of insurance. O'Mahoney meant that regulators should look for trouble, not just assume that "markets are always right," or that markets exist at all.

In Federal Trade Commission v. National Casualty Co., 357 U.S. 560, 563, 78 S.Ct. 1260, 2 L.Ed.2d 1540, the Supreme Court opined that the states could not meet the McCarran-Ferguson Act's contingent delegation of authority from Congress if the states established a "mere pretense" of regulation. Far too often, states and the insurance lobby establish many rules for insurers to follow, without creating more than a pretense of regulation. The members of the FSOC should keep this standard in mind as it deliberates.

Still, the ACLI comments argue that applying this analysis to life insurance organizations will demonstrate that life insurers do not pose systemic risk.

This position runs counter to one taken by the ACLI in the early 1990s, when the association approved of the NAIC officers asking the New York Federal Reserve Bank for a guaranty of liquidity for the life insurance sector in the face of numerous investment-based life insurance failures. In order to comply with statutory controls over such guarantees at the time, the NAIC had to argue that failures in the life insurance sector put the entire financial system at risk.

Once again, the ACLI argument is based on the assumption that most insurers engage in "traditional insurance company activities." As noted above, most insurers have long ago left the realm of traditional insurance company activities in order to engage in activities that used to be associated with investment banking and other securities firms.

The AIA suggests that the FSOC adopt a two-stage analytic process for implementing the DFA requirements. The AIA proposes that the FSOC first look to determine if a company could generate systemic financial instability and then look internally at the risk-related financial condition of those companies that merit further attention.

The first stage of this analytic framework is critical. Under it, AIA believes that the Council must consider the sector-specific context of any non-bank financial company, including the nature of the financial activities, the business model utilized, the relationship between the sector and the larger financial system, and the extent of regulatory supervision applied to the sector's market participants.

All of these industry-specific factors help inform the analysis of whether a specific company is so "interconnected" to the U.S. financial system that it could create instability.

Too big to fail

A major reason for the creation of the FSOC was to eliminate the concept of "too big to fail" from the lexicon of American finance.

Let's once again look at the AIG example. As indirectly stated above, AIG was "too big to regulate" before it became "too big to fail." Too big to regulate leads to too big to fail.

If AIG had failed, the state-by-state insurance guaranty fund system would have been overwhelmed, which would have resulted in catastrophic budget shortfalls in state capitals. While claims to guaranty funds are paid with funds raised through assessments against licensed insurers, those assessments are deductible from insurers' premium tax liability. In short, the industry only finances the guaranty fund system through lower premium taxes. State treasuries would therefore have less money coming in, to say nothing of the loss of premium tax revenue caused by the loss of one of the largest insurers. Had AIG been allowed to fail, the impact on state budgets would have resulted in an immediate and long-lasting financial disaster for state governments.

If for no other reason, as long as there is a guaranty fund system paid for through deductions from state premium tax liabilities, the insurance sector poses a systemic risk to the financial system of the United States.

The author

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 Insurance Cos. 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.