Federal regulators are supporting the insurance industry in its request for an exemption from the new regulatory regime for complex derivatives called “swaps,” which are mandated by the Dodd-Frank financial services reform law.
In a final rule approved Tuesday, the Commodity Futures Trading Commission exempted from oversight all traditional insurance products, according to Fred Bellamy, a partner at Sutherland, Asbill & Brennan in Washington, D.C. The CFTC, as well as the Securities and Exchange Commission, have been writing rules to complete the new derivatives regulatory structure that Congress included in the DFA, which was enacted by Congress in 2010.
Congress devised the new regulatory scheme to prevent reckless, speculative trading considered to be a key factor in the precipitous economic downturn that engulfed the world in 2007 and 2008.
The derivatives trading provisions, of which the swaps definition is a part, require that most derivatives be traded on open platforms and routed through a clearinghouse that secures the deal and collects margin from both sides.
The CFTC’s ruling mostly exempts insurance products because insurers enter into swaps transactions mainly to hedge against losses in products that have so-called “long tails”—contracts that go on long periods of time. In other words, insurers do not engage in derivatives trading for speculative purposes.
In the final rule, the CFTC also accepted a request by Congress that commercial companies and small banks with assets of $10 billion or less be excluded from the requirement to clear their trades. The banks argued the new requirements would be too onerous and tie up money that could be used for investment and lending.
Commenting on a comment letter sent by the Committee on Annuity Insurers on the proposed rule in July 2011, Bellamy said the annuity insurers’ letter made other suggestions. But changes made in the rule, as requested by the CAI, “are a vast improvement from the perspective of issuers of annuities and life insurance products.”
“Of course, we don’t know what other changes, if any, may be included in the final rule release,” Bellamy said.
In the fact sheet, the CFTC said it is clarifying in its final rules and interpretations “that certain types of products or transactions that could be covered by an expansive reading of the swap definition, but that traditionally have not been considered to be swaps, are not swaps.”
The fact sheet adds that, “These products and transactions include traditional insurance products that meet certain criteria, certain consumer and commercial arrangements, and certain loan participations.”
However, officials of a trade group representing property and casualty insurers said the final rule doesn’t go far enough.
Stef Zielezienski, senior vice president and general counsel of the American Insurance Association, said the PC industry recommended that the CFTC defer to state regulatory definitions of insurance, not propose a separate definition of its own.
“Therefore, our concern is that there will be a disconnect between the federal definition and state definitions of insurance products,” Zielezienski said.
The rule will state that insurance products sold by companies engaged in the business of insurance are not swaps or security-based swaps, according to the fact sheet.
The final rules include requirements for the product (the Product Test) and for the provider of the product (the Provider Test), the fact sheet states.
In addition, the CFTC said it is further defining certain traditional insurance products, such as life insurance and property and casualty insurance, “as not within the swap and security-based swap definitions.” That will be so “provided [the products] are offered by persons who meet the provider test” included in the final rule.
The CFTC noted in the fact sheet that it is clarifying that these rules are a “safe harbor,” meaning that just because a particular contract fails the requirements in the final rules, that does not necessarily mean the contract is a swap or security based swap; it will be evaluated under the facts and circumstances test established in the final rule.
In dealing with an issue considered critical by the annuity industry, the final regulation provided a separate safe harbor for annuities.
The CFTC said that if an annuity is offered through a provider that meets the requirements of the provider test in the final rules, “it will meet the requirements of the safe harbor and will not be considered a swap or security-based swap.”
At the request of the industry, the agency said it is not including a requirement that annuities be subject to certain tax treatment under the Internal Revenue Code that was contained in the initial proposal governing swaps regulation issued by the agency.
The final rule also exempts from the regulation small financial institutions, i.e., those with total assets of $10 billion or less.
Bellamy, the counsel for the Committee of Annuity Insurers, said that the final rule “meets or complies with” four of the primary requests made by the Committee of Annuity Insurers. Among them: specifying annuities in the Enumerated Products (that are not swaps) without the condition of meeting tax treatment under section 72 of the Internal Revenue Code.
The rule also codifies the proposed “interpretive guidance” as part of the rule itself (the “Enumerated Products”) and establishes that the rule is a safe harbor. The rule also includes a grandfather provision, Bellamy said.
This provision states that, “If a contract that was entered into on or before the effective date of the final rules, and it is offered in accordance with the requirements of the Provider Test in the final rules, the contract will not be considered a swap or security-based swap.”