Insurance regulation: A big ship now in motion

October 02, 2013 at 09:58 AM

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The regulation of American International Group (AIG) and Prudential Financial by the Federal Reserve Board as systemically important financial institutions (SIFIs), along with the government's ongoing examination of whether other insurance companies should also be designated as SIFIs, constitutes a major turning point for an industry whose oversight has been the exclusive domain of states since the nation's founding.

The SIFI designation issue is just one ripple in a tide of events that speak to significant changes in how the business of insurance is regulated — as well as to how the industry does business.

SIFI: Implications now and beyond

For SIFIs, designation means that these companies under the oversight of the Federal Reserve System, which will provide regulatory oversight in addition to the current state insurance regulatory framework for the insurers, according to officials at Moody's Investors Services.

Related story: SIFI impact to be ongoing

"In general, any company designated SIFI can be said to be entering a new reality of dual regulation," said Howard Mills, a former New York insurance superintendent and now a consultant at Deloitte.

Mills said such a designation "does nothing to change the fact that they will still be regulated by states. Whatever state they are domiciled in, that regulator will continue to be the primary regulator, but there will also be a federal regulator."

This type of federal regulation will bring much higher capital requirements and additional oversight on everything from consumer protection to market conduct. "It will simply become a more challenging regulatory environment with more opportunities to have regulatory problems," Mills said.

"Some have argued that this gives a company a marketing advantage because the consumer gets a perception that the federal government will not let that company 'go away.' That can't be proven yet, but it is an interesting counterpoint," Mills said.

Additionally, as Moody's has noted, if being a SIFI provides access to the Fed window for liquidity, these issuers could benefit from funds for unanticipated needs in a severe stress scenario.

Michael Nelson, chairman of insurance law firm Nelson Levine, raises another interesting point about the competitive issue. "It's the ultimate question, obviously, because some of the concern about being designated is higher capital requirements and higher regulatory costs. Companies that don't have that designation, are they in a superior position?"

Nelson notes that as time goes on and more and more companies are potentially exposed to the designation, the balance might change, and, as time develops, "you will get a better sense of what it means to be regulated as SIFI."

In other words, the impact of whether a SIFI designation is a burden or a competitive disadvantage remains to be determined, according to Nelson.

Robert Benmosche, president and CEO of AIG, explained that, at the end of 2014 or early 2015, AIG will be under that same capital review umbrella as the banks are.

"And that's not only what our capital ratio numbers are, but it's the quality of the systems that produce the numbers," said Benmosche. "So it's a very different game we're going to play in 2014 and beyond, once we're a part of the Comprehensive Capital Analysis and Review (CCAR) test, so then the Federal Reserve will have a lot to say about what we ultimately do and their satisfaction with what the numbers are."

Benmosche believes it is in AIG's best interests to be regulated by the Federal Reserve, however. He applauds the fact that his company has "an outstanding team from the Federal Reserve now at AIG," he said. "They are digging through everything we have, verifying everything we have, checking our policies, checking our procedures."

He notes that being under CCAR and being a SIFI will be a different level of regulation then what they are accustomed to, but that they need to run the company the right way. "And so that's what I think we are going to continue to do, and we're going to make sure whatever we do, we do not do anything to risk our credit ratings or to make our clients feel we're not able to live up to our guarantees," he said.

Prudential is seen as risky because of its holdings of, among other things, synthetic Guaranteed Investment Contracts (GICS), which make some on the FSOC nervous, according to sources who have worked with the FSOC staff.

For its part, Prudential has argued that, while they can't divulge the nature of their discussions with FSOC, they have said previously that their GICS contracts "contain manageable risks."

NARAB: A point positive

A major positive for the industry was the strong support voiced in the House last month for legislation creating a clearinghouse for licensing of insurance agents through the National Association of Registered Agents and Brokers (NARAB). Even though the idea has been around for more than a decade, this new support represents a major breakthrough. Passage of legislation creating such a clearinghouse by a strong majority in the House, as well as signs it has strong support in the Senate, also has major implications for how insurance is regulated and how its players conduct business. A passage by the House constitutes a major positive development.

NARAB, as envisioned by the legislation, would create a non-profit, independent board that would allow multistate licensing for insurance producers. Under the bill, insurance agents will be able to apply for NARAB membership and become licensed to sell insurance in multiple states, but states will maintain their full authority in regulating the business of insurance.

States would retain their regulatory jurisdiction over consumer protection, market conduct and unfair trade practices, and would retain their rights over licensing, supervision, disciplining and the setting of licensing fees for insurance producers, according to Ken Crerar, president/CEO of the Council of Insurance Agents and Brokers (CIAB).

Joel Wood, CIAB senior vice president for government affairs, said he has been walking the halls of Congress on NARAB in its various iterations for more than 20 years. The most frequently asked question he hears is whether it undermines state regulation or enhances it. "This thing would have gotten done years ago if it wasn't caught for so long in the crossfire of that ideological debate," he said. "Some wish for it to be the camel's nose under the tent that foretells greater federal involvement. Others see it as a protection of state governance that diminishes some sort of a federal invasion."

In practice, however, Wood views NARAB as simply an administrative mechanism to solve a series of regulatory problems that have been around for decades. He points to the intriguing politics on the matter, noting that "the congressional leadership on this has been truly bipartisan, at a time when Congress doesn't agree on much of anything," he said.

Wood is also impressed by the The National Association of Insurance Commissioners' (NAIC) support for the measure. "It's always easier to beat something than to pass something in Congress, and we have a couple remaining hurdles," Wood admits. "But for the first time, I believe we really can envision solving the bulk of the bureaucratic problems associated with nonresident producer licensure, and in a way that works for all the stakeholders regardless of their position on the spectrum of federal-versus-state regulation."

Rob Smith, president of the National Association of Insurance and Financial Advisors (NAIFA) agrees that NARAB would solve some long-plaguing issues regarding licensing. "Nearly 80 percent of NAIFA members have lost clients who moved to states in which they were not licensed, and 12 percent report that they have lost more than 50 clients this way," said Smith. "NARAB II would offer a common-sense solution to this problem," Smith said.

Mills believes that there has been a lot of interest in getting greater uniformity amongst the states, which he believes the industry will certainly welcome. "Similar standards for product approvals will obviously benefit the industry and consumers by enabling products to be brought to market faster," said Mills. "This is something that industry has long sought."

He believes that creation of the system will be a lengthy process since most everything in the insurance regulatory world is. "But, it is a good beginning," Mills said.

According to Nelson, from the agent perspective, "they are going to be thrilled with the prospect of more uniform licensing and greater reciprocity."

Nelson said companies still have to go through the process of appointing producers, including NARAB members, and it will be somewhat of a state-by-state approach by insurers. "I do think it is going to take off pretty quickly," he said. "A lot of agents want to participate in local markets and this is going to make it easier for them to do it."

Nelson said he believes that the latest initiative on capital by Benjamin Lawsky, superintendent of the New York Department of Financial Services (DFS), will have "serious implications" for the other insurance commissioners.

Nelson said that Lawsky is taking the position that the NAIC's capital adequacy approach for life insurers had not moved quickly enough and has not addressed adequately his concern that life insurers are under-reserved. "If Lawsky is correct, and I do believe the NAIC is involved, there is going to be a hard look at what Lawsky is saying," Nelson said. "There is more than a New York point of interest. It will be addressed by other regulators. And, the Federal Insurance Office (FIO) is watching this."

Lawsky is saying that the life insurance industry continues to be under-reserved and that the compromise constructed by state regulators for a new reserving method has failed, possibly imperiling policyholders and even the system of state-based regulation.

The issue is underpinned by one of the most important discussions happening in insurance regulation today, five years after the financial crisis and more than two decades after the collapse of huge life insurers, like Executive Life of New York (ELNY), that left policyholders with broken annuity promises: Capital.

The question he raises asks if there is enough capital to keep policyholders protected now and in the long-term. "Is there enough to keep the industry safe and keep it from causing a financial crisis?"

Principles-based reserving: Billions in the bucket

Lawsky's signature strong language, calling the almost decade-long reworking of actuarial guidelines a "recipe for disaster," was made in a letter Sept. 11 that was directed toward fellow state insurance regulators.

In it, Lawsky warned regulators of the new actuarial system they are seeking to adopt: Principles based reserving (PBR). It is used now by life insurers in a modified form under an agreement devised by the states for Actuarial Guideline 38 (AG 38) for certain in-force universal life products with secondary guarantees (ULSG).

Companies will be asked by New York to increase their reserves by billions overall. These companies include AIG, the Principle Financial Group, Lincoln National and others, a source confirmed.

Another company involved is Genworth Financial. Genworth, one of the companies issuing the policies, has previously told regulators that rules-based reserve approaches like the AG 38 guidance do not work well for products like ULSGs.

Genworth had said in discussions that PBR would be much more effective in establishing reserve levels that are appropriate in view of the insurance risk assumed.

Not all agree. In fact, the life industry, state insurance regulators, the actuarial body that worked on PBR, and even FIO to some degree support, or are expected to support, PBR as applied with oversight, resources and caution, according to sources. FIO will be issuing its modernization report "soon," and is expected to touch on the cornerstone of state regulatory reserving modernization, the PBR, without rejecting it, but supporting its prudent use, if states continue to monitor its application.

PBR is described as a more modern, flexible actuarial reserving set of principles that moves away from the formulaic method of the past, one that takes into account creative new life insurance products.

"I admire Superintendent Lawsky and consider him one of my closest colleagues at the NAIC, however, we simply differ on this important policy issue," said Connecticut Insurance Commissioner Tom Leonardi. "Principle-based reserving does not assume that regulators will blindly follow the company model and, if they do, they are not doing their job."

Leonardi said they can demand that the company change unreasonable assumptions, re-compute reserves based on the revised assumptions and require increases in reserves if necessary. The NAIC has taken this position before but did not directly reply to the latest Lawsky salvo.

"Even the Society of Actuaries agrees that the current system does not account for the highly complex products that have been devised over the past decade and that current reserves are probably too high or in some cases too low, so staying with the old system does not address this problem," Leonardi stated.

He noted that the property-casualty business has been using principal-based reserving without incident for quite some time and most developed countries also use it for life and annuity as well.

Captives: Creating controversy

There is another issue that is dividing state regulators and is being used by some to contend that FIO is violating state's rights by illegally intervening. This deals with the practice of insurers' use of captives and off-balance sheet and offshore vehicles to manipulate their capital. It emerged last month that Lawsky has acted to force such large insurers as AIG, Lincoln National and the Principal to increase their capital by as much as $4 billion.

Fitch Ratings weighed in with a report last month indicating concerns around the states' rush to raise revenues by facilitating the creation of captives by insurers seeking to increase costs and reduce reserves. The report said that the greatest risk to the recent increase in the number of captive insurance domiciles is the possibility that domiciles might sacrifice prudent regulatory oversight in order to attract and maintain a minimum number of captive registrations.

Fitch said that, this year, two more states have enacted captive insurance legislation and other states are in the process of drafting legislation facilitating chartering of captives. The two created so far this year brings the total number of U.S. states with captive legislation to 32, including the District of Columbia.

The report also said that, "This represents an increase of approximately 50 percent in the number of U.S. captive domiciles in the past 10 years." Nine domiciles license 100 or more captives, but half of the current U.S. domiciles license five or fewer captives, the report said.

"Some states view captive growth as an important potential source of revenue and some are very actively courting the captive market," said Don Thorpe, senior director at Fitch.

But, he said, "States will need to carefully manage the potential conflict of interest between rapid growth in captive registrations and prudent captive oversight."

Keith Buckley, managing director at Fitch, explains that while some captives will manage themselves with prudence regardless of the regulatory flexibility afforded them, Fitch suspects "many would weaken their risk management if allowed by weak regulation."

There are also practical operational risks linked to proliferation. Some jurisdictions may not be successful domiciles if they are unable to achieve the scale necessary to support a captive insurance regulatory infrastructure. Fitch believes there is also a risk that the proliferation of captive domiciles may strain the regulatory infrastructure, as currently there are a limited number of individuals with experience regulating captive insurance.

Despite the noted risks, Fitch believes the proliferation of captive domiciles also potentially provides captive sponsors with a number of benefits by keeping taxes and fees at reasonable levels; by streamlining the review and approval process; and by allowing sponsors to innovate new structures and uses for captive insurance.

Ultimately, prudent and balanced regulatory oversight would have the most favorable long-term effect on captive ratings. On the other hand, there would be a negative long-term rating effect if domiciles competed for captive registrations by weakening their regulatory frameworks.

And of course, there are other issues. An international group, the Financial Stability Board, has just issued a "peer review" on the U.S. regulatory system that suggests that "migration towards a more federal and streamlined structure may be a more effective means of achieving greater regulatory uniformity." And FIO has yet to issue a report due several years ago recommending ways of modernizing the U.S. insurance regulatory system.

All of this guarantees a continued, intense debate over the appropriate level of federal involvement in insurance regulation, a debate likely to generate friction between advocates of greater federal oversight over insurance activities, and those seeking to preserve the status quo.

Asked to summarize what is going on in a big ship that is now in motion, Nelson said, "All the systems are being reengineered, and with that comes a higher level of scrutiny. Obviously, the groundwork is being laid for many new ways to look at insurer solvency and insurer regulation."

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