The Obama administration plans to launch its effort to overhaul regulation of the financial services industry by seeking authority to regulate large non-bank institutions such as insurance companies and place them into conservatorship or receivership if they run into trouble.

That proposal, unveiled in March 26 testimony before Congress, is stirring great concern within the industry because it could have a substantial impact not only on the underlying insurance subsidiaries of an insurance holding company, but on the current, state-regulated resolution and guaranty system.

Treasury Secretary Timothy Geithner said the plan to regulate large insurers is only the first step in the federal government’s plan to overhaul financial services regulation in the wake of the current financial crisis.

Under questioning by members of the House Financial Services Committee, Geithner defended the current, state-based insurance regulatory system.

But, in answering questions and in follow-up comments by Treasury aides on a background basis, he made clear that after the priority issue of dealing with systemic risk is completed, Treasury is interested in examining whether an optional federal charter for insurers should be established.

“I think that we have to start by making sure we have in place effective, consolidated supervision over those entities that could pose potential risk to the system,” Geithner said. “Now, that does not mean that we should supplant and take away the existing
authorities that state insurance supervisors have over those institutions or that the bank regulators have over depositories.”

At the same time, he said that, going forward, “a good case” could be made for allowing carriers to choose to continue to
be regulated under the state-based insurance system or opt for oversight
under a new federal regulator.

He made this comment in answering a question by Rep. Ed Royce, R-Calif., co-sponsor of legislation, along with Rep. Melissa Bean, D-Ill., scheduled to be introduced April 2 that would create an optional federal charter for insurers, and impose strong consumer protections.

Also, in response to a question by Rep. Paul Kanjorski, D-Pa., chairman of the Capital Markets Subcommittee of the House Financial Services, about creating an Office of Insurance Information with the Treasury, Geithner replied, “I would not be opposed to an OII being established quickly” so as to create more insurance expertise in the Treasury Department.

“We would look forward to any help you could provide to us in that area,” he said.

The comprehensive framework for regulatory reform will cover four broad areas: systemic risk; consumer and investor protection; eliminating gaps in our regulatory structure; and international coordination, Geithner said.

“In the coming weeks, I will present detailed frameworks for each of these areas,” he added.

“Let me be clear: the days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers from losses must end,” Geithner said.

“We must cover financial institutions that have the potential to pose systemic risks to our economy but that are not currently subject to the resolution authority of the FDIC,” he added.

“This would include bank and thrift holding companies and holding companies that control broker-dealers, insurance companies, and futures commission merchants, or any other financial firm posing substantial risk to our economy,” he said.

As to authority to put into conservatorship or receivership, Geithner said, “The regulator of these entities will also need a prompt, corrective action regime that would allow the regulator to force protective actions as regulatory capital levels decline, similar to that of the Federal Deposit Insurance Corporation with respect to its covered agencies.”

The proposal to give the FDIC resolution authority over troubled large insurance companies is something the industry should look at closely, according to officials at the National Association of Insurance and Financial Advisors and a lawyer who deals with liquidation of troubled insurers.

“NAIFA is currently examining the full potential impact of Geithner’s proposal on the insurance industry,” said a NAIFA spokesman.

“Our initial reaction is that the proposal would usurp state insurance regulators’ authority to oversee and approve changes in control of insurance subsidiaries owned by an integrated financial services conglomerate that is in financial peril,” the spokesman said.

“NAIFA cautions the administration and Congress that removing this critical authority from the industry’s functional regulator could cause great harm to the industry and its policyholders,” he said. ?

Francine Semaya, a lawyer with Nelson Levine de Luca & Horst LLC, in New York, added, “I think state insurance regulators should closely examine how under the proposed regulatory scheme the resolution authority is going to work in the event an insurance holding company runs into financial difficulty where it might be subject to the Treasury’s power to place a troubled insurance holding company under the FDIC for resolution.”

Clearly, she said, “it will impact how the regulators and the insurance companies continue to function.”

For example, Semaya said, “some of the operating subsidiaries may not be subject to conservatorship and receivership, and how does the insurance regulator continue to ensure protection of the policyholders of those entities that are not subject to takeover?”

In his testimony, Geithner said the characteristics of the insurance company the administration wants authority to regulate in the first tranche of regulatory reform include “the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding.”

Another characteristic will be the importance of the firm “as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.”

Eric Dinallo, New York insurance superintendent, said in reaction to Geithner’s testimony that what they are looking for is “some kind of oversight and resolution of the holding companies and lightly regulated parts of these conglomerates, like we saw at American International Group.

“I believe that insurance companies standing alone, even very large ones, don’t present the same systemic risk as the financial supermarkets or large, leveraged institutions,” Dinallo added.

At the same time, Dinallo lauded Geithner. “I think it is a serious plan.”

He also said Geithner is doing a good job. “At least he is doing something, rather than nothing,” Dinallo said.

In general, Dinallo said we “should remain flexible, not idealogical. It took Treasury Secretary Henry Morgenthau and President Franklin Roosevelt 10 years to work out of the Depression. We can’t just give Mr. Geithner 10 weeks. And, we have to try different things.”