On June 3, 2016, the Board of Governors of the Federal Reserve System (Board) issued two important documents with implications for certain insurance companies. One document is an advance notice of proposed rulemaking (ANPR) seeking public comment on proposed capital standards for systemically important insurers (SIIs)1 and insurers subject to the Board's supervision as a result of their ownership of a federally insured bank or thrift (Non-SIIs).2 The other document is a notice of proposed rulemaking (NPR) seeking public comment on proposed new rules that would establish enhanced prudential standards for SIIs in the areas of corporate governance, risk management and liquidity management and planning. These documents were previewed in Governor Daniel Tarullo's speech at the International Insurance Forum in Washington DC on May 20, 2016, which we summarized in our May 24 Legal Update.

Capital Standards for Non-SIIs and SIIs

GUIDING OBJECTIVES In developing capital standards for Non-SIIs and SIIs, the Board seeks to achieve two primary objectives:

  • Protecting insured depository institutions; and
  • Promoting financial stability in a manner that recognizes both the unique form of financial intermediation in the insurance business and the activities of a few firms that are much more closely connected to short-term financial markets and the rest of the financial system.

The Board believes that those two objectives suggest adopting different approaches for Non-SIIs and SIIs.

The ANPR notes that any minimum capital requirements must satisfy the Dodd-Frank Act's Collins Amendment, which requires the Board to establish minimum leverage capital and riskbased capital requirements that, on a consolidated basis, are at least as stringent as those in effect on July 21, 2010 and at the present time for insured depository institutions.3 As amended in 2014, the Collins Amendment provides the Board with flexibility to tailor these capital requirements to the risks presented by insurance companies.4 The ANPR states that the proposed capital standards are intended to complement the primary mission of state insurance regulators, which tends to focus on policyholder protection.

The Board appears to acknowledge that the liability structures, asset classes and assetliability matching of insurers differ from those of bank holding companies. However, the Board notes that capital standards need to take into account both insurance and non-insurance risks and, to the extent possible, should take into account risks across the entire holding company system. The Board notes that a contagion can spread from unregulated subsidiaries to regulated ones (citing in particular the AIG experience during the financial crisis). The Board also seeks to advance standardized and consistent capital requirements rather than allowing a group to rely predominantly on internal models.

NON-SIIs

The ANPR proposes a "building block approach" (BBA) for Non-SIIs. Under the BBA, capital requirements at each regulated subsidiary (e.g., insurer, bank or thrift) would generally be determined using the regulatory capital rules (including risk-based capital) already applied to that subsidiary by the relevant regulator, which could be a state or non-US insurance regulator in the case of an insurer. (Unregulated subsidiaries would be analyzed using the existing standardized risk-based capital rules applicable to nonbank subsidiaries of bank holding companies.)

A holding company's aggregate capital requirements generally would be the sum of the capital requirements at each subsidiary with adjustments to address items such as differences in accounting, to eliminate intercompany transactions and to reflect "other crossjurisdictional differences such as differing supervisory objectives and valuation approaches." The BBA would involve developing a translation matrix--referred to as "scalars"--to put different regulatory regimes on an equivalent footing and then applying that matrix to address "intercompany transactions and other exposures (such as permitted accounting practices for insurers)." Scalars also would be used to ensure adequate reflection of safety and soundness and financial stability goals, rather than policyholder protection, as well as other relevant considerations. Notably, the ANPR does not specify scalar values or categories and invites comment on the criteria the Board should use to develop scalars.

The goal would be to impose some type of enterprise-wide capital requirement without forcing Non-SIIs to incur the burdens and costs associated with moving to consolidated financial reporting on a GAAP basis.

The Board notes that at present the BBA would apply to the 12 insurance depository institution holding companies currently under Board supervision as SLHCs (there are currently no such BHCs). The ANPR invites comments on whether larger or more complex insurers that might in the future acquire a depository institution should be subject to a regulatory capital framework other than the BBA.

SIIs For SIIs, the Board is considering a modified consolidated capital framework, or "consolidated approach" (CA), because of the risks those entities pose to financial stability. Accordingly, the CA would use consolidated financial information based on GAAP, with adjustments for regulatory purposes. The ANPR states that applying the CA to insurance depository institution holding companies that do not file US GAAP financial statements would require the development of a consolidated approach based on statutory accounting principles (SAP).5

The consolidated insurance group's assets and liabilities would be segmented with each segment receiving a risk weighting that takes into account the longer-term nature of most insurance liabilities. The consolidated capital requirements would then be compared to the corresponding qualifying capital and measured against a minimum ratio of required capital. The number of risk categories could be increased over time to achieve greater risk sensitivity as the Board gains experience with the CA. The regulatory capital framework for SIIs therefore would be similar in scope and structure to the basic regulatory capital framework for bank

2 Mayer Brown | US Federal Reserve Invites Public Comment on Capital Rules for Insurers Subject to Its Supervision holding companies, though with perhaps some more favorable risk-weightings and other potential adjustments tailored to the insurance business.

Prudential Standards for SIIs

As background, Section 165 of the Dodd-Frank Act directs the Board to establish enhanced prudential standards for BHCs with at least $50 billion in total consolidated assets and nonbank financial companies designated by FSOC as systemically important financial institutions (SIFIs, of which SIIs are a subset) in order to prevent or mitigate risks to US financial stability that could arise from the material financial distress or failure, or ongoing activities, of these companies.6

In 2013 FSOC designated AIG and Prudential as SIFIs, meaning that they would be subject to supervision by the Board, including with respect to enhanced prudential standards. In 2014 the Board adopted enhanced prudential standards for larger BHCs, and noted that it would implement enhanced prudential standards for SIFIs (including SIIs) through subsequent rulemakings. The NPR is such a rulemaking. Once final rules are adopted, SIIs (i.e., AIG and Prudential) will be expected to comply with the enhanced prudential standards on the first day of the fifth quarter following the effective date (about a year).

As outlined in the NPR, two types of enhanced prudential standards would apply to SIIs: (i) corporate governance and risk management and (ii) liquidity risk management, including a contingency funding plan and stress testing. These standards would be tailored to the insurance industry. The corporate governance and risk management standard would require the SII to have a chief actuary who would monitor reserve adequacy on an enterprise-wide basis and would require a separate risk committee, the chair of which must be independent of the company, that would report to the board of directors. Also, in light of the different nature of insurance liabilities, the liquidity risk-management standards would apply a 90-day planning horizon for the liquidity stress-testing requirement instead of the 30-day planning horizon applicable to large BHCs.

Request for Public Comment

The ANPR and the NPR include many questions on which the Board is soliciting input. An overarching concern is how the BBA will interact with the existing state insurance regulatory regime, including state-by-state variations in accounting and capital treatment and the effect of permitted (as distinguished from proscribed) accounting practices under SAP. To cite just a few examples, the ANPR invites public comment on:

  • Criteria to be used to develop scalars for different jurisdictions;
  • Whether the same capital framework should apply to all supervised insurance institutions;
  • Criteria the Board should use to determine whether a supervised insurance institution should be subject to regulatory capital rules tailored to the business of insurance;
  • What activities, in addition to insurance underwriting, should be used to determine whether a supervised institution is significantly engaged in the business of insurance and therefore should be subject to regulatory capital requirements tailored for insurance;
  • To what extent the BBA and/or CA could be subject to regulatory arbitrage;
  • Whether the BBA would be appropriate for larger or more complex insurers that might in the future acquire a depository institution; and
  • How qualifying capital should be defined for purposes of meeting the capital requirements and whether qualifying capital should be categorized into multiple tiers.

The deadline for submitting comments on the ANPR and the NPR is August 2, 2016. As of this writing, there has been no public comment on the ANPR or the NPR from the National Association of Insurance Commissioners.