The Federal Reserve Board’s new — and first — vice chair for supervision speculated that credit derivatives could cause a crisis for life insurers nearly three years before life insurers began reporting huge losses on credit default swaps.

Randal Quarles, who was confirmed as a member of the Fed on Thursday, by a 65-32 vote, warned about derivatives risk in July 2006, at a hearing on insurance regulation organized by the Senate Banking, House and Urban Affairs Committee. 

Quarles, who was under secretary for domestic finance at the U.S. Treasury Department in 2006, acknowledged at the hearing that the design of an insurance policy tends to limit the amount general financial systemic risk that could be caused by the failure of a large insurer.

“Nonetheless,” Quarles said, “there remains some potential for disruptions in the insurance market to impact economic and financial markets. And, importantly, these potential risks may not be well understood at either the state or the federal level.”  

(Related: Treasury Official Discusses Federal Role In Insurance)

Quarles suggested that one possible source of insurance company risk could be an insurer’s activity as a lender, or as the counterparty in derivatives tied to debt.

“For example,” Quarles said, “there has been a considerable amount of attention paid to the expanding credit derivatives market.”

A counterparty involved in some types of credit derivatives arrangements makes a payment when certain events occur, Quarles said.

The role of the counterparty in that type of arrangement is similar, in some ways, to the role of an insurer, and, in 2006, insurers appeared to be taking a more active role in the credit derivatives market, Quarles said.

“From an overall perspective of market stability, do we fully understand what risks insurance companies are undertaking, or how their activity could impact the credit derivatives and other financial markets?” Quarles asked.

Seven months later, in February 2008, American International Group Inc. reported an $11 billion unrealized market valuation loss on its credit default swaps operation.

Fourteen months later, in September, AIG acknowledged publicly that it was facing severe financial distress and needed help from the government to unwind its credit default swaps operations.

Federal Reseach Building (Photo: AP)

(Photo: AP)

At the same hearing, Quarles said that, although the U.S. state-based regulatory system has strengths, such as regulators’ knowledge of local market conditions, it can also also lead to inefficiency, and to an insurance regulatory blind spot at the federal level.

The structure of the insurance regulatory system “limits the ability of any one regulator to have an overview of risk in the insurance sector and its contribution to risk in the financial system more broadly,” Quarles said.

Quarles also talked about concerns about the convergence of different types of wealth management vehicles.

“Many wealth management products serve a similar purpose (e.g., variable annuities and mutual funds), but are offered by firms with different charters and underlying regulatory structures,” Quarles said. “Any underlying economic reason for treating like products differently for regulatory purposes has blurred over time.”

Quarles did not recommend any regulatory changes, but he said the federal government should get a better understanding of how differences in regulation, such as different capital standards and tax rules, might affect the flow of capital.

The committee has posted a written version of Quarles’ 2006 testimony here.

Quarles also touched on insurance company, briefly, in July, when the Senate Banking Committee held a hearing on his nomination by President Donald Trump to serve on the Fed.

Sen. Tim Scott, R-S.C., an insurance agent, asked Quarles about his views on systemic risk at life insurers.

Quarles said he believes that, in theory, a large life insurer might face some systemic risk, if all of its policyholders tried to take the cash value out of their life insurance policies at the same time. But he added that he views that scenario as remote and unprecedented.

“So, I think that the risks that are posed by insurance companies are quite different” from the risks posed by banks, Quarles said.

The committee posted a video of that hearing, and a copy of the written version of Quarles’ testimony, here

Quarles has a bachelor’s degree from Columbia and a law degree from Yale.

He served as the U.S. executive director of the International Monetary Fund from August 2001 through April 2002, then spent five years at the Treasury Department.

He worked for about six years as a managing director at the Carlyle Group L.P. For the past year, he has been helping to start and run the Cynosure Group, a private equity firm based in Salt Lake City.

Another Cynosure managing director, Cynosure, Spencer Eccles, previously ran the state’s economic development office, which oversaw the state’s Affordable Care Act public health insurance exchange. Eccles was a member of the Utah exchange steering committee.

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