At its June 3, 2016, open meeting, the Federal Reserve Board approved two regulatory proposals that would lay the groundwork for the Fed to apply enhanced prudential standards for systemically important insurance companies and establish tailored capital requirements for institutions engaged in significant insurance activities as required by the Dodd-Frank Act.
Fed Governor Daniel K. Tarullo telegraphed the Fed’s action in a May 20, 2016, speech to the National Association of Insurance Commissioners’ International Insurance Forum (see Banking and Finance Law Daily, May 20, 2016).
Capital requirements. In its advance notice of proposed rulemaking (ANPR), the Fed is seeking comments on two approaches—the Building Block Approach and the Consolidated Approach—that would be used to establish regulatory capital requirements for supervised insurance institutions.
The two approaches were developed from input received and considered through engagement with insurance regulators, industry and accounting experts, and representatives from the insurance industry, among other interested parties. The two approaches also meet the requirements of section 171 of the Dodd-Frank Act, referred to as the Collins Amendments, especially 2014 amendments that provide the Fed with flexibility to tailor these capital requirements to the risks presented by insurance companies.
Covered institutions. The type of approach used to establish capital requirements would be based on the type of insurance institution. Either approach would apply to either nonbank financial companies significantly engaged in insurance activities that the Financial Stability Oversight Council has determined shall be supervised by the Fed—systemically important insurance companies, and bank holding companies (BHCs) and savings and loan holding companies (SLHCs) significantly engaged in insurance activities, commonly known as insurance depository institution holding companies. An insurance depository institution holding company is a company that has 25 percent or more of their total consolidated assets in insurance underwriting subsidiaries other than assets associated with insurance underwriting for credit risk.
Currently, there are two systemically important insurance companies—American International Group, Inc. (AIG), and Prudential Financial, Inc. Other the other hand, the Fed is the supervisor for 12 SHLCs that are considered to be insurance depository institution holding companies. There are no BHCs that meet the insurance depository institution holding companies criteria.
Building block approach. Under the building block approach, the existing legal-entity capital requirements for insurance companies would be used as a starting point. These existing capital requirements include state and foreign insurance risk-based capital requirements, and the BHC or bank risk-based capital standards for banking, non-insurance, and unregulated entities.
A firm’s aggregate capital requirements generally would be the sum of the capital requirements at each subsidiary. This sum would be adjusted to address items such as differences in accounting and to eliminate inter-company transactions, and scalars to reflect other cross-jurisdictional differences such as differing supervisory objectives and valuation approaches.
Consolidated approach. The consolidated approach would be used for the two institutions that are large, complex, international, and systemically important—AIG and Prudential.
The consolidated approach would be based on U.S. Generally Accepted Accounting Principles and categorize all of a consolidated insurance firm’s assets and insurance liabilities into risk segments tailored to account for the liability structure and other unique features of an insurance firm. The consolidated approach would apply risk factors to the amounts in each segment and then set a minimum ratio of consolidated capital resources to consolidated capital requirements.
During the Fed’s meeting, it was noted that the consolidated approach would help prevent intra-group regulatory arbitrage opportunities and the potential for double leverage. In addition, the consolidated approach would provide a good foundation on which to build a consolidated supervisory stress testing framework.
One possible drawback of the consolidated approach would be the need for additional analysis to design a set of risk factors for all of the assets and insurance liabilities of systemically important insurance companies.
Enhanced supervision. The second proposal approved by the Fed would implement the requirements of section 165 of the Dodd-Frank Act that directs the Fed to establish enhanced prudential standards for nonbank financial institutions that the FSOC has designated to be systemically important insurance companies. If finalized, the enhanced prudential standards would apply to AIG and Prudential.
The proposal would require any systemically important insurance company to:
- maintain an enterprise-wide risk-management framework, including related policies and procedures;
- create a risk committee of its board of directors that is responsible for the company’s risk-management policies and framework and have a chief risk officer and a chief actuary; and
- have its board of directors, risk committee, and senior management establish liquidity risk management standards.
The liquidity risk management standards would need to provide short- and long-term cash-flow projections, a contingency funding plan, liquidity risk limits, and procedures for monitoring liquidity risk. In addition, a systemically important insurance company would need to conduct liquidity stress tests on a monthly basis and maintain a liquidity buffer sufficient to cover its net stressed cash flows over a 90-day period.
Although the proposed enhanced prudential standards are based on enhanced prudential standards that have been adopted by the Fed for large and complex banking organizations, they would be tailored for systemically important insurance companies to reflect the systemic footprints, business models, capital structures, and risk profiles of systemically important insurance companies.
Commenting the capital ANPR, Tarullo noted, " Incorporating the tiering principle into financial regulation both promotes achievement of our regulatory mission by applying more stringent regulation to firms that pose greater risks to the financial system and helps avoid the imposition of unnecessary compliance costs on those that pose lesser risks."
Fed Chair Janet L. Yellen added, "[T]his proposal is an important step toward capital standards that are both appropriate for our supervised insurance firms and that enhance the resiliency and stability of our financial system."
Companies: American International Group, Inc. (AIG); Prudential Financial, Inc.
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