Public Policy Analysis & Opinion

The gorilla grabs top bananas from the 57 monkeys

FSOC designates AIG and GE Capital as presenting systemic risk

By Kevin P. Hennosy

The Wall Street Journal of February 5, 1998, carried a feature article by investigative reporter Scot J. Paltrow. The article quoted former Missouri Director of Insurance Jay Angoff, who observed that insurers preferred oversight from the states. He opined that the insurance sector would prefer to deal with 50 monkeys rather than one big federal gorilla.

Today, the Delaware-chartered corporation doing business as the National Association of Insurance Commissioners, or NAIC, lists its "membership" as including all 50 states, the District of Columbia and six U.S. territories—which equates to 57 monkeys.

The Financial Stability Oversight Council (FSOC) announced on July 8, 2013, that two American non-bank financial institutions presented systemic risk to the world financial system: American International Group, Inc. (AIG), and General Electric Capital Management (GE Capital).

The long-sleeping gorilla had reached in and grabbed two "top bananas" out of the monkey house.

According to U.S. Treasury Secretary Jacob "Jack" Lew, who serves as chair of the FSOC, "These designations will help protect the financial system and the broader economy from the types of risks that contributed to the financial crisis. The Council will continue to review additional companies in the designations process, to address remaining threats to financial stability."

The FSOC systemic risk designation does not tarnish the companies as experiencing financial weakness. On the contrary, the U.S. financial regulators seem to be asserting that the two institutions have "more money than God."

However, as the world learned in the Financial Panic of 2008, such concentrations of wealth and risk can melt down with disastrous consequences.

The FSOC acted under the authority established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The act recognized that some financial institutions can become so large or occupy such vital bottlenecks in the financial system that they cannot be left to the tender mercies of egocentric regulators.

The financial collapse of AIG in September 2008 provides a "poster child" example of how a large financial institution can capture its supposed regulators and operate between jurisdictional lines. After the "world's largest insurer" had bullied the state insurance commissioners for several generations, the Delaware-chartered corporation which does business as the NAIC sent a poor sot to Capitol Hill to claim that AIG was not an insurance company. Yeah, Right! I guess the several states should return all those premium taxes and agent license fees that local jurisdictions collected from AIG, its agents and brokers. (I assume any state treasurers will not be writing any such reimbursement checks to AIG.)

The FSOC Web site explains the Systemic Risk Designation as follows:

Under Section 113 of the Dodd-Frank Act, the Council is authorized to determine that a nonbank financial company's material financial distress—or the nature, scope, size, scale, concentration, interconnectedness, or mix of its activities—could pose a threat to U.S. financial stability.

Just as AIG's failure did in 2008.

The FSOC statement continues:

Such companies will be subject to consolidated supervision by the Federal Reserve and enhanced prudential standards.

Since AIG has been overseen by a delusional cabal of chastised state officials, who had convinced themselves that the world's largest insurer was not an insurance company, presenting the insurer with "enhanced prudential standards" should not be difficult.

On June 16, 2013, former Senator Ben Nelson delivered testimony before the House Subcommittee on Housing and Insurance and Financial Services on behalf the NAIC. It is reasonable to speculate that Nelson, NAIC officials and senior staff knew of the impending FSOC designation at the time of the hearing.

With regard to international systemically relevant insurers, Senator Nelson informed the subcommittee: "[We] continue to examine the scope of our authorities and resources to ensure that systemic risk does not emanate from activities or entities within our purview."

If one reads the testimony with care, it becomes clear that state insurance regulators oppose the importance of systemic risk because new federal laws move those entities from the parochially friendly confines of state-based regulation to federal oversight. The concern relates to loss of jurisdiction over a big pile of money—which might generate campaign contributions.

Of course, the loss of leverage for campaign contributions is rarely discussed in the salons of insurance regulation. In such conversation, the phrase "negative market implications" encompasses similarly unpleasant topics of conversation, ranging from campaign contributions to total financial collapse and the unspeakable fact that companies become "too big to regulate" before they are "too big to fail."

As Nelson testified, "While it is entirely appropriate to identify insurers that pose clear risks to the financial system at home or abroad, given the potential for negative market implications, such designation should be the product of a rigorous analysis that reflects a thorough understanding of the insurance business model and regulatory system, and demonstrates that these high standards are met."

Obviously, the FSOC deemed that AIG and GE Capital exceeded Nelson's "clear risks to the financial system at home or abroad" standard.

With respect to AIG, the FSOC mainly applied the designation based on the firm's size:

Because of AIG's size and interconnectedness, certain characteristics of its liabilities and products, the potential effects of a rapid liquidation of its assets, potential challenges with resolvability, as well as other factors described herein, material financial distress at AIG could cause an impairment of financial intermediation or of financial market functioning that could be sufficiently severe to inflict significant damage on the broader economy.

The FSOC took into account that AIG is a smaller company today than what it was when its financial implosion nearly triggered another round of Dark Ages. For example, the company is now "only" the third largest insurer in the United States. Nevertheless, FSOC recognized that AIG remains a powerful concentration of wealth and risk. "AIG remains a large and complex company with meaningful non-insurance-related exposures."

The statement first establishes that AIG still plays a vital role as an insurer, faces the weight of risk inherent to an insurer, but has also loaded on large amounts of risk generated by non-insurance financial operations.

As this column has noted several times in the last decade, insurance companies become increasingly fixated on financial schemes. Too often insurance products become bait designed to attract relatively small amounts of money from large numbers of people for use in financial operations. The 19th century Elizur Wright life insurance exposé, Traps Baited With Orphans, comes to mind.

The FSOC's explanatory statement on the AIG systemic risk designation highlights the firm's exposure to "run on the bank style" surrenders of life insurance products as a risk that would impair its financial stability. The FSOC recognizes that the impairment of AIG would destabilize the U.S. financial system.

In addition, the FSOC statement mentions AIG's dominance in certain commercial insurance sectors, which gives AIG "a major role in the provision of certain commercial insurance coverages that are highly capital intensive and difficult for policyholders to replace in a short timeframe."

In addition to the risk piled on AIG, the FSOC observed that the insurance giant was primarily engaged in financial transactions. The FSOC is not trying to explain away the AIG failure as the NAIC did. The FSOC is trying to take action to avoid another failure.

This is the kind of attention to systemic disruption that state insurance regulators have avoided doing. The state-based regulatory approach has been significantly dumbed-down in the past 13 years since the repeal of the Glass-Steagall Act.

The repeal of Glass-Steagall increased the destructive dynamic of a regulatory race to the bottom, where insurers threatened state regulators to seek federal charter legislation if states did not undermine regulatory oversight. An increasingly brittle structure remains in place where regulators maintain checklists approved by the carriers' lobbyists, and if all the little boxes are filled in, the company is deemed "regulated."

But what if something goes wrong? What if even something small in a powerful and influential company goes seriously wrong? Would there not be a butterfly-effect within the company, or across the holding company, or through the insurance sector or even across far-flung commercial sectors?

For want of a nail, a boot was lost

The NAIC issued a response to the FSOC on July 11, 2013. After opening its statement with a cooperative and conciliatory tone, the NAIC statement slips into denial. The NAIC statement proposes:

While this designation is not unexpected given AIG's role in the financial crisis, the reasoning offered by FSOC to justify the designation suggests a misunderstanding of the insurance business model and regulation of insurance.

The NAIC statement explains, "Elements of FSOC's rationale focus on the scope of AIG's insurance activities and theorize about the potential for a 'run-like' scenario for certain insurance products or a broader loss of public confidence in the insurance sector. However, during the recent financial crisis—the worst since the Great Depression—state regulators closely monitored surrenders and withdrawals at AIG and its competitors, and the insurance sector did not suffer a run or the same loss of public confidence experienced by the banking sector."

The NAIC's rosy scenario quickly breaks down under scrutiny. First of all, life insurance accounting allows insurers to report bond investments at par value, which did not accurately reflect financial condition.

Of course, by the time the state regulators "closely monitored surrenders and withdrawals," the rotten hulk of AIG was already filling up with $180 billion of public money and the promise of more.

Furthermore, a material number of life insurance companies received TARP funds from a horrendously traumatized U.S. Congress. Had not that public money flowed to AIG and other life insurers, the state regulators would have had many more instances of surrenders to "monitor"—through their tears. Why do I make that brash assumption? Because I have seen it happen.

I remember the last time that the life insurance sector suffered … "runs." In the early 1990s, after state regulators failed to take the junk-bond punch bowl away from the party, life insurers began collapsing under the weight of investment risk. There were runs on individual insurers—such as Executive Life Insurance Company (ELIC).

Yes, it is true that the contractual provisions of the ELIC annuities forbid large numbers of annuitants from tendering surrender orders—but the company still failed. The "fear and loathing" spread throughout the life insurance sector.

A series of life insurance companies failed that might have survived had ELIC's self-immolation not happened before so many agents and customers. Public confidence in life insurance plummeted. The life insurance sector suffered a financial panic.

When it comes down to basics, insurance is built on confidence. Public officials and insurance professionals must recognize the need for affirmative regulation to maintain public confidence.

In order to restore public confidence lost in the financial scandals of the 1980s, Congress forced the NAIC to lobby legislatures and regulators to enact its Solvency Policing Agenda—but NAIC officers still made a secret trip to the New York Federal Reserve Bank to beg for a guarantee of liquidity for the life insurance sector if things got any worse.

The July 11 NAIC statement also denigrated the FSOC assessment of AIG's importance to the commercial insurance market.

"While the exit of a market leader could be disruptive, within the insurance sector there is a proven history of a robust, competitive market absorbing the business of failing insurers and attracting new capital."

Well, if NAIC management genuinely believes that fairytale, I have but one direct question for them: Hey Rube, you wanna buy a bridge?

Instead of FSOC misunderstanding insurance and its regulation, we may be looking at NAIC losing touch with its last links to reality. The FSOC is trying to act to prevent the kind of financial collapse that came about because state insurance regulators found it impossible to stand up to AIG. State regulators found it impossible to do their jobs in the face of a financial behemoth.

Perhaps federal officials will stand a better chance. Perhaps.

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.