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.”
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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.
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.