The amount of capital that insurers are required to hold on their balance sheets has become a regulatory and legislative flashpoint. A convergence of factors over the last few years – including federal rulemaking under The Dodd-Frank Wall Street Reform and Consumer Protection Act, oversight of "systemically important" financial institutions, ComFrame, NAIC's group solvency initiatives and other regulatory activity – is significantly changing how insurance companies determine the amount of capital they need and how regulators oversee insurers' risks and resources.
Among other developments, Section 171 of Dodd-Frank (the so-called Collins Amendment) requires federal financial regulators to impose capital standards on certain financial firms (depository institution holding companies and systemically important firms) at least as rigorous as those applicable to the individual banks or S&Ls within those groups. It has been suggested that this would require the federal regulators to impose bank-style standards on such firms even where the firm is an insurer – an anomaly, to say the least, because of the vastly different capital and liquidity needs of banks and insurers.
Legislation currently pending in Congress would explicitly reject this possibility and bring some much-needed clarity to this area. Senate Bill 2270 and its companion in the House, H.R. 4510, would expressly permit the federal agencies to exclude insurers in considering capital requirements for such diversified firms. This would be consistent with the original intent of the Collins Amendment (as stated by Senator Collins herself) and should encourage the Federal Reserve to tailor capital standards accordingly. It also would align the Collins Amendment more closely with Section 165 of Dodd-Frank, which expressly permits the Fed to customize regulatory requirements for firms depending on the nature of their business. S. 2270 passed the Senate earlier this year; H.R. 4510 remains pending in the House.
The pending legislation would theoretically permit the Fed, in determining the capital adequacy of insurers within larger financial institutions, to consult traditional capital tests under state insurance laws, or even use them as a proxy. Such state-law rules, most prominently the risk-based capital (RBC) regime, could be a useful tool for federal regulators, and accordingly many in the insurance sector have embraced the legislation. Many believe that RBC is a more accurate and appropriate measure for insurance company capital needs because, among other things, it measures not only liquidity risks associated with investments but also reinsurance, reserves and other sector-specific aspects of insurance firms. Allowing the Fed to leverage this regulatory tool would obviate, at least in part, the need to fit the square peg of insurers within the round hole of bank regulation. To this end, the ability to consult insurance capital standards would be consistent with the widely held view that insurers per se do not pose systemic risk to the economy, while still allowing the Fed to exercise its mandate to oversee diversified firms that do pose such risk (or that are depositary institution holding companies within the Fed's jurisdiction).
A recent press item ("Insurers' Capitol Fix Comes with a Catch," Wall Street Journal, July 29, 2014), however, cautions that this seemingly elegant outcome might not be completely possible due to Section 939A of Dodd-Frank (which limits the use of credit ratings in Federal regulation), and that therefore this legislative "fix" for insurance regulation might inadvertently fall short of its goal.
To illustrate, consider a hypothetical diversified financial firm that includes insurers and other types of entities and that falls within the Fed's regulatory jurisdiction under Dodd-Frank. In determining the needed amount of capital for the consolidated firm, the Fed would be required to impose FDIC- or Basel III-style standards on the entities within the group that are banks (and possibly others). In order to ascribe a component of the firm's risk to the group's insurer(s), the Fed might choose to consult determinations already made under state law as suggested above. These determinations could be based, in part, on the RBC regime.
Such state-based standards might ascribe a different degree of risk to certain insurer-held investments from those that would apply under bank-centric rules. Commentators have observed that part of the reason for this is that state-imposed RBC rules base certain capital charges on credit ratings of individual investments made by insurers. By contrast, Section 939A of Dodd-Frank prohibits federal agencies from even referring to rating agencies in their regulations. Therefore, it is argued, the Fed would not be able to use a pure state-based approach and would have to apply the more stringent federal banking-type capital adequacy tests in this key area. Under this view, the goal of insulating insurers from bank-type regulation would be partially frustrated by the language of Dodd-Frank itself.
Careful consideration of the language of Dodd-Frank suggests that this may be an illusory problem, or at least an exaggerated one – in other words, federal regulators may be able to refer to state regulatory rules, even under Section 939A. Admittedly such provision does require federal agencies to "remove [from their regulations] any reference to or requirement of reliance on credit ratings." However, it is not at all self-evident that the two provisions (Section 939A and an amended Section 171) cannot coexist and both be given effect. The fact that the Fed has the flexibility to exclude insurers does not necessarily mean that, if the Fed does include insurers, it may not rely on or even refer to state-law-based determinations of solvency. In its overhaul of U.S. financial regulation, Dodd-Frank contains numerous carve-outs for state-regulated insurance companies and accommodates the role of state regulators. For instance, in Dodd-Frank's provisions on an "orderly liquidation authority" for resolving failed financial companies, insolvent insurers continue to be subject to state-law receivership provisions. In the provisions governing investments in hedge funds and private equity funds (the so-called Volcker Rule, comprising Section 619 and related federal regulations), key exceptions are extended to insurance companies. These carve-outs illustrate a consistent, largely "hands-off" approach to insurance, leaving insurance to be regulated by the states as it has been historically. Consistent with this approach, it seems perfectly legitimate for the Fed to refer to state-law provisions for setting capital requirements for insurers, even though those state-law provisions refer to credit ratings in the risk assessment of bonds.
It would be ironic if a legislative fix designed to restore the Collins Amendment to its original meaning would expose insurers to additional risk of being subject to bank-centric standards. While it is unclear as of this writing what action, if any, the House will take on this issue in the remainder of this Congress, stakes are high.
Published September 23, 2014.
