Daniel K Tarullo: Insurance companies and the role of the Federal
Reserve
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the National Association of Insurance Commissioner's International Insurance
Forum, Washington DC, 20 May 2016.
* * *
It is a pleasure to be here with you this morning to discuss the statutory role of the Federal
Reserve in supervising and regulating insurance firms. Since we inherited from the Office of
Thrift Supervision the oversight of savings and loan holding companies (SLHCs) that contain
insurance companies, we have looked at our role as complementing the role you - as
insurance regulators - play. We value the interaction we have had with state insurance
commissioners on policy matters and are pleased with the growth of ongoing, regularized
cooperation in supervising the firms over which we both have oversight authority. Personally,
I have profited enormously from the assistance provided by the staff of the National Association
of Insurance Commissioners (NAIC) as I delved into the history and practice of capital
regulation of insurance companies.
Today I would like to begin by describing how I view the Federal Reserve's role in insurance
regulation and supervision - both what it is and what it is not. As I think you will find, we have
tried to occupy that role in a way that is closely grounded in the duties that Congress has given
us. Then I will present current thinking on a topic that I know has occasioned great interest -
the Federal Reserve's plans for adopting capital requirements for the insurance firms over
which we now have statutory responsibilities.
The Federal Reserve's role in insurance regulation and supervision
The U.S. insurance industry has historically been, and remains, a significant part of the U.S.
economy. For the industry across all sectors, written premiums last year totaled nearly
$2 trillion and earned premiums totaled nearly $1.8 trillion, representing increases from 2014
of approximately 6 percent and 4 percent, respectively.1 This represents over 7 percent of U.S.
gross domestic product, as it has in recent years.2 The two largest sectors in the U.S. insurance
industry, property/casualty and life/annuities, together wrote approximately $1 trillion of
premiums in 2015, up nearly 3 percent from the year prior.3 Moreover, for the U.S. insurance
industry as a whole, written and earned premium last year were the highest in five years.4
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) gave the
Federal Reserve regulatory responsibilities both for insurance holding companies that own a
federally insured bank or thrift and for insurance companies designated as systemically
important by the U.S. Financial Stability Oversight Council (FSOC). The insurance holding
companies for which the Federal Reserve is the consolidated supervisor hold about $2 trillion
in total assets, representing about one-quarter of U.S. insurance industry assets. These firms
are highly diverse: they range in size from firms with total assets of approximately $3 billion to
firms with total assets of over $700 billion. They engage in a wide variety of insurance and
noninsurance activities. Some are fully domestic, while others have material international
operations. Some are organized as mutual companies, while others are owned by public
shareholders.
The approach of the Federal Reserve in regulating insurance holding companies is derived
from its overall statutory responsibilities for financial regulation as those have evolved over the
years, most recently through the changes made by the Dodd-Frank Act. First, as was the case
prior to the enactment of the Dodd-Frank Act, we are responsible for protecting the safety and
soundness of federally insured depository institutions affiliated with any kind of holding
company. With the Dodd-Frank Act's transfer of SLHC oversight to the Federal Reserve, that
statutory responsibility now includes insurance holding companies. While the particulars are
somewhat different than for bank holding companies, the aim and many of the tools to achieve
this aim are the same.
Second, the Dodd-Frank Act sharpened our statutory mandate to make clear that the Federal
Reserve is to regulate and supervise holding companies with a view to the safety and
soundness of not only the holding company itself, but also its functionally regulated
subsidiaries, including affiliated insured depository institutions. Again, while the particulars
differ, this mandate applies to SLHCs as well as to bank holding companies.5 The
GrammLeach-Bliley Act of 1999 had, at the least, rendered ambiguous the question of whether the
Federal Reserve could take supervisory measures that involved a functionally regulated
subsidiary of a holding company unless a specific threat to an affiliated depository institution
could be established. The financial crisis underscored the importance for safety and
soundness of not waiting until problems in the holding company were manifestly affecting the
depository institution.
Third, the Dodd-Frank Act also changed our statutory mandate to require that we regulate
holding companies so as to promote the stability of the financial system as a whole. This means
paying attention to interconnections among financial firms, correlations of asset holdings, and
other characteristics that could endanger the nation's financial stability during periods of stress.
One of the most notable differences between the Dodd-Frank Act and other financial legislation
over the preceding half century is the frequency with which the phrases "financial stability" and
"systemic risk" occur, either as the specific goal of certain new provisions or as a consideration
to be taken into account in administering general regulatory authorities. As I have explained
elsewhere,6 this systemic or "macroprudential" regulatory aim does not apply equally to all
holding companies or banks. Indeed, with respect to community banks, for example, it does
not really apply at all. It is important that financial regulation be tiered so as to regulate for the
kinds of risks various groups of financial institutions actually pose, rather than to regulate in a
monolithic fashion.
Fourth, for all the broadening of our statutory mandate, one feature of the financial regulatory
system that the Dodd-Frank Act preserved was the functional regulation of holding company
affiliates based on the kind of financial intermediation in which they are engaged. Thus, even
though we do apply consolidated capital and liquidity requirements at the holding company
level, we do not specifically apply them to broker-dealer, commodities merchant, or investment
company affiliates. Nor do we have any role in the investor protection and market functioning
mandates in the regulatory regimes administered by the Securities and Exchange Commission
(SEC) and the Commodity Futures Trading Commission. Similarly, we have no role in
regulating the types of insurance offered by affiliates of the holding companies we supervise
or the manner in which the insurance is provided. These matters are the province of state
insurance regulators. In fact, because of the overall structure of insurance regulation as
specified by Congress in the McCarran-Ferguson Act and elsewhere, the line here is arguably
brighter than in other areas.
In pursuing what might be termed its dual regulatory mandate of protecting the safety and
soundness of depository institutions and their holding companies and promoting financial
stability, the Federal Reserve must develop regulatory and supervisory measures that are
appropriate for a range of non-bank financial intermediaries. Consider, for example, the risks
associated with bank holding companies containing large broker-dealer operations. Unlike
traditional commercial banks whose activities are funded with retail deposits, these bank
holding companies are typically heavily reliant on repurchase agreements (or repos) and other
types of short-term wholesale funding. The events of 2007 to 2008 reminded us that, while this
type of funding may be very stable during normal times, it can disappear overnight in periods
of stress. Runs by providers of short-term wholesale funding may not only precipitate the failure
of an individual firm by depleting that firm's capital and liquidity buffers, but also precipitate
contagion that can imperil the rest of the financial system.
As a result of this very dynamic during the financial crisis, the five large, formerly freestanding
broker-dealers have mostly been absorbed by, or converted into, bank holding companies. In
our post-crisis development of liquidity requirements and stress testing, and in reforming
capital requirements, we needed to pay particular heed to these critical funding differences
between traditional commercial banks and broker-dealers. Similarly, in building out our
regulation and supervision of insurance companies, we are paying particular attention to how
their funding patterns differ from other forms of financial intermediaries.
Here, though, the major relevant difference is that the funding structures of traditional insurers
are generally much more stable than the funding structures of commercial banks, much less
broker-dealers. A traditional insurance company's liabilities are largely composed of contingent
claims based on the occurrence of specified events, such as the death of an insured person
or the destruction of property. Because these claims generally cannot be accelerated,
companies engaged in traditional insurance activities are less vulnerable to runs and,
accordingly, to short-term pressures to sell assets into declining markets. This insulation from
creditor runs in turn suggests that capital and liquidity requirements for insurance companies
should be calibrated differently than capital and liquidity requirements for dealer banks.
Because Congress modified the Collins Amendment in late 2014, we can now tailor capital
requirements for insurance companies.
However, it is important to add that the balance sheet of an insurance company can look quite
different from the traditional picture I have just sketched. For example, a life insurer may offer
investment and retirement products with account values that can be withdrawn at the discretion
of policyholders, sometimes with little or no surrender penalty. The option to surrender creates
the potential for increased claims that could strain the liquidity of the firm. Relatedly, the
extensive involvement of an insurance firm in securities lending, repo, over-the-counter
derivatives, and other capital markets activities can create a balance sheet with much tighter
connections to the rest of the financial system and greater liquidity risk in times of financial
market stress. As with other financial intermediaries, insurers then become subject to demands
for posting additional collateral or closing out positions as unfavorable market conditions take
hold. In addition, if the positions of the insurance company are large enough, it could become
a potential vehicle for transmitting distress at the company to other parts of the financial
system.
The foregoing considerations suggest that we should distinguish between insurance
companies that we oversee solely because they own an insured depository institution and
those that have been designated as systemically important by the FSOC. This is precisely the
path we are taking with regard to our supervision of these firms. For the former group, our
supervisory efforts to date have focused on ensuring that the companies have strong internal
controls and effective corporate governance, as well as satisfactory risk identification,
measurement, and management. For firms designated as systemically important, our
supervision has additionally emphasized capital and liquidity planning and positions,
management of core business lines, and recovery and resolution planning. Board staff meets
with the primary state insurance departments that supervise the insurance companies for
which we have consolidated supervisory responsibility and, together with lead state
supervisors, we co-host supervisory colleges and crisis management groups for AIG
(American International Group, Inc.) and Prudential. We continue to discuss supervisory plans
and findings for the insurance firms, extend invitations for joint inspection activities, and discuss
common areas of supervisory focus.
As you likely know, the Board is also working to develop a regulatory framework for its
supervised insurance companies. The Dodd-Frank Act authorizes the Board to establish
minimum capital requirements for both systemically important insurance companies and
SLHCs and bank holding companies predominantly engaged in insurance activities. For
systemically important insurance companies, the Dodd-Frank Act directs the Board to establish
enhanced prudential standards in order to mitigate risks to U.S. financial stability that could
arise from the material distress, failure, or ongoing activities of these companies. The
enhanced prudential standards must include, among other things, enhanced capital
requirements, liquidity requirements, corporate governance and risk-management standards,
and resolution planning requirements. We have already established resolution planning
requirements for the systemically important firms. At present, we have three major regulatory
initiatives underway for our supervised insurance firms: first, reporting requirements for the
systemically important firms; second, enhanced corporate governance, risk management, and
liquidity standards for those same firms; and third, capital requirements for all supervised
insurance firms. Let me say a few words about the first two and then spend the rest of my
remarks on capital requirements, which I know are probably of the greatest interest.
About a month ago, the Federal Reserve proposed new reporting requirements specifically for
the systemically important insurance companies.7 These reporting requirements are designed,
among other things, to keep us informed as to the financial condition and risk profile of these
firms, as well as the extent to which their activities and operations could pose a threat to the
financial stability of the United States. The proposed reporting requirements differ substantially
from reporting requirements for bank holding companies, and from available U.S. Generally
Accepted Accounting Principles (U.S. GAAP) financial information filed with the SEC. They are
highly tailored to the assets, liabilities, and risks of insurance companies. We look forward to
receiving public comment on the proposal.
Regarding enhanced prudential standards, the Federal Reserve's enhanced corporate
governance and risk-management standards for systemically important insurance companies
will likely build on the core provisions of our consolidated supervisory framework for large
domestic and foreign banking organizations, with appropriate adjustments to reflect these
firms' predominantly insurance business model.8 The framework will mandate standards for
the systemically important insurance companies to follow in managing risk and will identify the
parties responsible for ensuring the integrity of a company's risk-management practices.
Enhanced liquidity requirements will likely include internal control requirements, general
comprehensive cash flow projections, contingency plans to manage liquidity stress events, and
internal liquidity stress testing requirements. I expect that these proposed enhanced prudential
standards for systemically important insurance companies will be considered by the Board in
the coming weeks. Of course, we look forward to public comment on these standards, once
proposed.
Capital requirements for insurance companies supervised by the Federal Reserve
In formulating capital standards for the insurance companies we supervise, our goals should
track our overall goals in financial regulation, as I described them a few moments ago. Thus
we should aim, first, to protect depository institutions and, second, to promote financial stability
in a manner that takes account of both the unique form of financial intermediation reflected in
the traditional insurance business and the activities by a few firms that are much more closely
connected to short-term financial markets and the rest of the financial system. As with some
of the other measures I have mentioned, these factors argue for different approaches to capital
requirements for the systemically important insurance companies, on the one hand, and for
the rest of the insurance companies we supervise, on the other. That is, indeed, the direction
in which I believe we are headed.
There are, as all of you know, a lot of ideas out there as to how we should construct the capital
requirements we will apply to insurance companies. Some, such as variations on the Solvency
II approach used in the European Union, strike us as unpromising. The valuation frameworks
for insurance liabilities adopted in Solvency II differ starkly from U.S. GAAP and may introduce
excessive volatility. Such an approach would also be inconsistent with our strong preference
for building a predominantly standardized risk-based capital rule that enables comparisons
across firms without excessive reliance on internal models. Finally, it appears that Solvency II
could be quite pro-cyclical.
Other ideas have some conceptual appeal, but strike us as impractical for the foreseeable
future. Most prominent among these is an approach based on internal cash flow stress testing.
The appeal of this idea lies in its melding of capital and liquidity considerations. The relationship
between a firm's capital levels and liquidity profile is something that needs to be kept in mind
when formulating regulatory regimes for all forms of financial intermediaries. However, as I
noted earlier, we are reluctant to rely on internal models for basic regulatory capital
requirements, which makes this idea less appealing to us. The novelty and untested nature of
this idea as a basis for regulation would, in any case, necessitate extensive development, likely
over a period of years. While we have consciously taken a good bit of time in considering a
capital regime for our supervised insurance firms in order to make sure we get it right, we
cannot wait years more, especially because there is no guarantee that even this investment of
effort would produce a feasible internal models-based capital rule. However, I think it is worth
continuing to explore internal cash flow stress testing as we build the supervisory stress testing
program for systemically important insurance companies.
Another set of possibilities is raised by the work of the International Association of Insurance
Supervisors (IAIS). As part of its effort to create a common framework for the supervision of
internationally active insurance groups, the IAIS began work on a comprehensive insurance
capital standard (ICS) in 2013, issued an initial consultative proposal on the ICS in late 2014,
and will continue work on the ICS for at least the next few years. The ICS would be the first
international, group-wide capital standard broadly applicable to internationally active insurance
groups and would incorporate internationally compatible valuation principles, definitions of
capital resources, and risk-based capital requirements for assets and insurance liabilities.
Progress in developing such a global capital standard for internationally active insurance firms
has been slow. I will mention some of the difficulties that have been encountered. First, there
is considerable heterogeneity among the insurance products offered in different jurisdictions.
As one example, annuities and other savings and retirement products tend to be offered less
frequently in countries with relatively expansive government pension programs. In the context
of developing capital requirements, a second factor has been jurisdictional variations in
accounting and valuation standards on which global capital requirements for insurance
companies can be built. A third factor has been significant disagreement on the extent to which
capital standards for internationally active insurance companies should be built on internal
models. These challenges and the protracted process they have occasioned have, as a
practical matter, rendered the ICS insufficiently developed to be an option as the Federal
Reserve moves forward with capital requirements applicable to the insurance companies we
supervise.
A second relevant initiative of the IAIS involves the design of an enhanced regulatory and
supervisory framework for global systemically important insurers (G-SIIs). In 2014, the IAIS
released the Basic Capital Requirement (BCR) for G-SIIs. It is the first international
consolidated capital standard developed for the insurance industry. The IAIS developed the
BCR in an effort to ensure the soundness of global insurance firms with the largest systemic
footprints. In 2015, the IAIS supplemented the BCR with a Higher Loss Absorbency (HLA)
capital standard for G-SIIs. But the IAIS will need to revisit the BCR after the first version of
ICS is complete and will also need to revisit HLA after further refinement is made on its G-SII
identification methodology. This somewhat provisional character of the BCR, along with its
reliance on a method of valuation not in use by U.S. companies and regulators, mean it does
not really fit our need for an approach that can - as a practical matter - be developed and
implemented in the relatively near term.
These are some of the paths we do not intend to take in formulating capital requirements for
insurance firms. The approach we do intend to follow will be elaborated in what I anticipate will
be an advance notice of proposed rulemaking (ANPR) to be issued in the coming weeks. As I
suggested earlier, the ANPR will likely put forward two different methodologies - one for the
insurance firms that we supervise solely because they own a bank or thrift and the other for
the firms designated as systemically important.
A. Insurance companies owning a bank or thrift: the building block approach
The Federal Reserve has traditionally set capital requirements for holding companies on a
consolidated basis. Among other things, a consolidated capital standard deters firms from
moving assets around its affiliates in order to take advantage of lower requirements applied to
different affiliates for particular assets. Insofar as publicly traded banking organizations are
required by securities laws to file consolidated, U.S. GAAP-consistent financial statements,
there is both a parallelism between accounting and capital regulation and a measure of
economy in the compliance costs of a consolidated capital rule.
In contrast, most insurance firms subject to our regulation only because they own depository
institutions do not produce consolidated financial statements. Furthermore, Congress has
prohibited the Federal Reserve from requiring insurance firms that file only Statutory
Accounting Principles (SAP) financial statements to produce U.S. GAAP consolidated financial
statements.9 Given that these firms have not been designated systemically important and that
the depository institutions they own tend to be relatively small parts of the total firm, the
compliance costs of requiring a move to some non-U.S. GAAP form of consolidated approach
may well not be worth the incremental safety and soundness benefits of doing so. Together,
these considerations are leading us to what we refer to as the building block approach (BBA),
which is likely the approach that we will put forth for comment in the ANPR for this group of
firms.
The BBA would aggregate capital resources and capital requirements across the different legal
entities in the group to calculate combined, group-level capital resources and requirements. A
firm's aggregate capital requirements generally would be the sum of the capital requirements
at each subsidiary. The capital requirement for each regulated insurance or depository
institution subsidiary generally would be based on the regulatory capital rules of that
subsidiary's lead regulator - whether a state or foreign insurance regulator or a federal banking
regulator for depository institutions. The regulatory capital requirement for any non-insurance,
non-banking subsidiaries - which at present are relatively minor parts of these firms - would
probably be determined under the standardized risk-based capital rules applicable to affiliates
of bank holding companies.
Should we adopt this approach, we will need to develop a formula or scalar to put the different
regulatory regimes on a comparable basis. With an eye towards the kind of issues that are
usually addressed by a consolidated capital approach, we will also need to fashion standards
for adjustments to address inter-company transactions and possibly some other exposures.
An example of the latter would be potential adjustments to harmonize permitted accounting
practices that vary across states.
The BBA would efficiently leverage existing legal-entity-level regulatory capital frameworks that
already apply to the various units of the supervised insurance group. As such, it would involve
relatively low regulatory burden for these entities, even as it produces regulatory capital
requirements that are reasonably well tailored to the insurance-related risks for each distinct
jurisdiction and business line of the group.
B. Systemically important insurance companies: the consolidated approach
By definition, the insurance companies designated by the FSOC are systemically important.
For these firms, application of an aggregated approach like that of the BBA could pose
significant risks to the Federal Reserve's statutory aims of safety and soundness and financial
stability. The BBA, recall, would simply aggregate capital requirements that may not be
founded upon financial stability considerations. A consolidated form of capital requirements is
key to ensuring that risks to the financial system as a whole (as compared, say, to investor or
policyholder protection) are accounted for.
For these firms, then, the ANPR is likely to seek comment on what we have internally been
calling the consolidated approach (CA). Let me note at the outset that this is not the
consolidated capital framework we apply to bank holding companies. As with our capital
requirements for bank holding companies, the CA would categorize all of the consolidated
insurance group's assets and insurance liabilities into risk segments, apply risk factors to the
amounts in each segment, and then set a minimum ratio of required capital comparing the
consolidated capital requirements to the group's consolidated capital resources. However, the
CA would use risk weights or risk factors that are more appropriate for the longer-term nature
of most insurance liabilities.
Like the BCR of the IAIS, the CA would take a consolidated approach to capital requirements.
However, unlike the BCR, the foundation of the CA would be consolidated financial information
based on U.S. GAAP, with appropriate adjustments for regulatory purposes. Our current
thought is that the CA would initially be relatively simple in design, with a relatively small
number of risk categories. Thus there would be a broad risk segmentation of asset classes
and insurance liabilities. However, as we gained experience with the CA, we would have the
option of making it increasingly granular in order to achieve greater risk sensitivity.
The CA, as a consolidated capital framework, would help prevent intra-group regulatory
arbitrage opportunities and the potential for double leverage.10 It would also be compatible with
supervisory stress testing, which - as you all know - is now a central component of our
supervisory program for making systemically important firms highly resilient, as well as for
giving us a more complete picture of risks in the financial system as a whole. Obviously, the
compliance costs associated with the CA will be higher than those of the BBA. But this
enhanced regulation is justified by the increased risks to the financial system associated with
these firms. Indeed, it is our obligation under the Dodd-Frank Act to impose stricter regulation
on these firms. Even so, by constructing a separate consolidated approach to capital for
systemically designated insurance firms, compliance costs for these firms should be
considerably lower than if they had to conform to the bank holding company capital regime.
Finally, I would note that adoption by the Federal Reserve of a fully consolidated capital
requirement for systemically important insurance companies might also help advance the
international development of appropriate and effective capital requirements for insurance firms
of global systemic importance.
Conclusion
As noted earlier, the Board's prudential regulatory objectives pertaining to supervised
insurance companies are to protect the safety and soundness of the consolidated company,
to protect any subsidiary depository institutions of the company, and to mitigate any threats to
financial stability that might be posed by the activities, material financial distress, or failure of
the company. Just as we have done with other non-bank financial intermediaries for which we
have been given regulatory responsibilities, we will fashion a regime that takes account of the
particular characteristics and risks of those intermediaries. We have taken a good bit of time
in arriving at some potential insurance regulatory capital frameworks precisely because we
wanted to consider these issues thoroughly. Our tentative conclusion is that a bifurcated
approach to a capital regime for insurance companies makes sense in light of these
considerations. But we anticipate using the vehicle of an ANPR in order to give all interested
parties an opportunity to comment on this approach before we turn to developing and
proposing its details. In this process, we of course especially welcome the views of those of
you on the front lines of insurance supervision.
Thank you very much.