Domestic insurers and reinsurers other than Prudential Financial could face consolidated regulation by the Federal Reserve Board, judging from the Sept. 19 majority opinion of the Financial Stability Oversight Council (FSOC) on the SIFI-designated insurer, although members would be quick to point out under the Dodd-Frank Act (DFA) that each case is judged upon its merits and will not create any spillover effect.
However, others point out that the sheer size of Prudential, and its interconnectedness, rather than its activities, are part of the basis for the FSOC’s 7-2 vote that the Newark, N.J.-based behemoth is a systemically important financial institution (SIFI).
This rationale of looking at the totality of the enterprise tees up other large insurance firms for similar scrutiny, from Berkshire Hathaway with its huge insurance holdings to private equity firms gaining control of annuity providers to even the large mutual life insurers. It depends if the company is judged to have 85 percent of its annual gross revenues or 85 percent of its total consolidated assets derived from activities that are financial in nature, as required for SIFI consideration under the DFA.
Under the statutory standard, the Council assumes material financial distress in its analysis of Prudential–or any company it reviews for SiFI status–as a starting point. It is supposed to look at the company as if facing material financial distress. The majority did so, outlining a now controversial scenario in which most — if not all — policyholders were trying to surrender, withdraw or otherwise cash in their policies and pensions from Prudential’s hundreds of subsidiaries. The FSOC majority only then looked at the impact to the broader economy and found it shaken. Read the Basis here.
The cataclysm is envisioned to happen by forced asset liquidations, which would topple asset values at other life insurers, leading to reputational ruin of the sector, asset fire sales and a general loss of confidence in similar financial institutions, culminating in instability within the economy as a whole.
As one dissenter noted, “I believe that, absent a catastrophic mortality event (which would affect the entire sector and also the whole economy), such a corporate cataclysm could not and would not occur.”
But even financial firms that have small exposure to a variety of firms but large exposure in the aggregate, as Prudential was characterized by the FSOC, have gotten into trouble and caused ripples throughout the broader economy, which has some federal officials worried that if they did nothing, a larger-scale event involving Prudential would shake the economy.
While “individual exposures to Prudential may be small relative to the capital of its individual counter-parties. In the aggregate, however, the exposures across multiple markets and financial products are significant enough that material financial distress at Prudential could aggravate losses to large, leveraged financial firms, which could contribute to a material impairment in the functioning of key financial markets or the provision of financial services by Prudential’s counter-parties,” the FSOC majority wrote, noting derivatives exposure in particular.
“For example, if Prudential were to experience material financial distress, the company’s derivatives portfolio could be a source of risk to its derivative counter-parties, which could experience losses through unwinding bilateral derivative trades. The largest of Prudential’s derivative counterparties also have other significant exposures to Prudential,” FSOC pointed out.
Discordant views at the Council
Not all agree and the vote, viewed as inevitable by many, was hard won among those who did or would have dissented, including independent insurance expert Roy Woodall, the Acting Director of the Federal Housing Finance Agency Ed DeMarco and nonvoting member John Huff, the National Association of Insurance Commissioners’ (NAIC) representative, also Missouri insurance director.
Read the dissents here.
“The underlying analysis utilizes scenarios that are antithetical to a fundamental and seasoned understanding of the business of insurance, the insurance regulatory environment, and the state insurance company resolution and guaranty fund systems,” Woodall stated.
The robustness of the state insurance regulatory system, guaranty funds and all, came up short in the analysis by FSOC and the insurance parties called out the majority for giving the state system short shrift. The “existing regulatory scrutiny” is a factor in the analysis for the proposed SIFI designations.
Dissenters, also, among other concerns see the designated insurers as never being able to shed the SIFI skin once they are sheathed in it — that the Federal Reserve Board has no intention of letting go. That’s because the basis for the SIFI designation by the majority does not address any activities the insurer could limit or exit, but more its overall profile.
Using the same rationale, other large life insurers such as MetLife, already in stage three of SIFI review, and a number of other life insurers over the $50 billion in assets threshold could be viewed as potential SIFIs. These include the large mutual life insurers and MidAtlantic or Midwestern players.
However, MetLife and Prudential dwarf by total assets the next largest U.S. life insurer, Lincoln National. Berkshire Hathaway is huge, with Geico and General Re but as FSOC nonvoting member Michael McRaith, director of the Federal Insurance Office (FIO), pointed out in House testimony in May 2012, “When a traditional insurance business fails, not every car owner is going to get into a car accident immediately upon dissolving … there is not the same prospect of a run.”
Some argue that the fate of Prudential was sealed when it, with MetLife and AIG, were voted as global systemically important insurers (G-SIIs) by the Financial Stability Board (FSB) as announced July 18. This means that their “national regulator” would need to develop certain capital and oversight standards and restrictions for them. Some argue this would have to be the Federal Reserve, or Treasury, under Dodd-Frank, as a “national authority” who “apparently assented to the FSB designation of Prudential as a G-SII — even prior to Prudential’s evidentiary hearing before the Council,” Woodall wrote.
McRaith said in the May 2012 testimony that FIO was working with the IAIS on the “criteria, methodology and timing” of SIFI designations “so no U.S. insurer is disadvantaged through global designation of [SIFIs].”
Troubled international waters
“Although not binding on the Council’s decision, the declaration of Prudential as a G-SII by the FSB based on the assessment by the U.S. and global insurance regulators, supervisors, and others who are members of the [International Association of Insurance Supervisors (IAIS) has overtaken the Council’s own determination process.” Woodall asserted.
Woodall, as he has pointed out in dissent and Congressional testimony, is an insurance voting member of FSOC yet is not admitted under a fall 2012 proposed change in by-laws to the Basel-based IAIS membership body, and feels thwarted. Woodall said he is not “privy” to the secret deliberations of the IAIS – as members of the the NAIC, FIO and World Bank are, and voiced suspicion at the FSB designations and their possible bearing on the SIFI process domestically. Some international insurance supervisors would also want to bring more people to the table at the IAIS meetings if by-laws are changed for U.S. stability personnel so some see a change in by-laws as opening the floodgates to more foreign banking supervisory types.