Although the insurance industry was not the primary target of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act),1 the Act represents an unprecedented step by the federal government into insurance, an area traditionally regulated by the states. The Act seeks to address three main areas of congressional concern with respect to insurance. First, the Act grants the newly created Financial Stability Oversight Council (the Council) authority to subject large, interconnected insurers to Federal Reserve Board supervision, addressing Congress’s view that nonbank financial institutions whose operations make them systemically important to the U.S. financial system require centralized supervision. Second, in response to Congress’s belief that federal regulators lack sufficient knowledge of the insurance industry, the Act creates the Federal Insurance Office to monitor the industry, gather industry data and report to Congress, among other tasks. Finally, the Act streamlines certain aspects of state insurance regulation, specifically those relating to surplus line insurance and reinsurance. This article examines the importance of these three portions of the Act to the insurance industry.
Financial Stability Oversight Council
To address concerns that financial regulators were too disjointed to foresee the crisis that gripped the U.S. financial system beginning in 2008, the Act created the Council to prevent and mitigate systemic risks that toppled large financial institutions and prompted federal bailouts. The Council is composed of 10 voting members and five non-voting members. The voting members are the Treasury Secretary (who chairs the Council) and the heads of the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Housing Finance Agency, the National Credit Union Association, the newly established Bureau of Consumer Financial Protection and an insurance industry expert appointed by the President. The non-voting members are the director of the newly created Office of Financial Research within the Treasury, a state banking commissioner, a state securities commissioner and, important to the insurance industry, a state insurance commissioner and the director of the Federal Insurance Office.
The Council is tasked with identifying systemic risks to the financial stability of the United States posed by large bank holding companies and nonbank financial companies, responding to emerging risks throughout the financial system and promoting market discipline. To address the risks posed by nonbank financial companies, the Act empowers the Council to subject these companies, including insurers, to Federal Reserve Board supervision and enhanced prudential standards. In making such a determination, the Act sets forth the following factors that the Council must consider: the company’s leverage, off-balance-sheet exposure and interconnectedness to other large financial institutions; the importance of the company as a source of credit and liquidity; the extent to which the company manages, rather than owns, assets; the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company; the degree to which the company is already regulated; the amount and nature of the financial assets of the company; the company’s liabilities and any other risk factors the Council deems appropriate.2
On January 26, 2010, the Council published in the Federal Register a notice of proposed rulemaking setting the specific criteria and analytical framework by which it will consider designating nonbank financial companies for supervision by the Federal Reserve Board.3 The Council would use the framework in meeting its statutory obligations of assessing the threat a nonbank financial company may pose to the financial stability of the United States, taking into consideration the factors set forth in the Act described above. The proposed framework consists of the following six categories:
- lack of substitutes for the financial services and products the company provides
- interconnectedness with other financial firms
- liquidity risk and maturity mismatch, and
- existing regulatory scrutiny.
The Council further classified the six categories into two subgroups. The first three categories, size, lack of substitutes, and interconnectedness, point to the potential for a firm’s distress to “spill over” and affect the broader financial system. The remaining three categories, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny, implicate how vulnerable a company is to financial distress.
Pepper Points: In proposing the analytical framework, the Council maintained the broad authority to subject a nonbank financial company to Federal Reserve Board supervision granted to it in the Act. The proposed six categories are similar to the factors set forth in the Act, and the Council stated in the proposing release that “each of the statutory factors in … the [Act] would be considered as part of one or more of the six analytical categories.” This likely reflects the reluctance of regulators to narrow their ability to designate a nonbank financial company as being systemically important, thus giving them greater flexibility to deal with such a company in the event of a future financial crisis.
Despite the Council’s broad authority, currently there are few insurers that likely would fit into the proposed framework. Unlike large investment banks, for example, few insurers have large derivatives and securities business lines that make them interconnected to a systemically important degree with other financial institutions. Further, the sheer number of competitors provides ample substitutes for insurance services should any large insurer fail. Insurance also is one of the most highly regulated of all industries. Although more insurers may begin to fall into the Council’s framework as time passes and business practices change, we believe that at the present time very few insurers need to be concerned about potential Federal Reserve Board supervision.
Federal Insurance Office
Effective July 22, 2012, the Act creates a new Federal Insurance Office within the Treasury Department to:
- monitor, gather information and report on the insurance industry
- recommend to the Council that it subject an insurer to Federal Reserve Board supervision
- coordinate federal efforts and develop federal policy on prudential aspects of international insurance matters and assist Treasury in negotiating certain international agreements relating to insurance (Covered Agreements)
- preempt state laws and regulations that are inconsistent with a Covered Agreement and favor U.S. insurers over non-U.S. insurers
- assist in administration of the Terrorism Insurance Program
- consult with states regarding insurance matters, and
- identify gaps in insurance regulation that could contribute to a systemic crisis.
The Act does not, however, grant the Federal Insurance Office regulatory authority over the industry, nor does it create a federal insurance charter.
Monitoring and Information Gathering
In passing the Act, Congress felt that federal regulators lacked expertise in insurance, an area traditionally subject to state law. Congress therefore granted the Federal Insurance Office significant authority over monitoring and information-gathering, but not regulatory authority. It has subpoena powers to collect from insurers and their affiliates data necessary to carry out its functions discussed above. However, the Federal Insurance Office first must attempt to obtain the information from public sources and state insurance regulators, and the Act contains an exemption for “small” insurers to be defined by Federal Insurance Office regulation. Importantly, if an insurer submits any nonpublic information, it will not waive any privilege and the information will remain subject to any existing confidentiality agreements.
International Matters, Covered Agreements and Preemption
The Federal Insurance Office will also oversee international insurance affairs, including developing U.S. policies, representing the United States in the International Association of Insurance Supervisors, and assisting the Treasury Secretary in negotiating Covered Agreements.
If the Federal Insurance Office determines that a state insurance law (i) results in less favorable treatment of a foreign insurer domiciled in a foreign jurisdiction that is subject to a Covered Agreement than a U.S. insurer domiciled, licensed, or otherwise admitted in that state, and (ii) is inconsistent with a Covered Agreement, it may preempt the state law. However, the ability of the Federal Insurance Office to preempt state law shall not extend to: any state insurance measure that governs an insurer’s rates, premiums, underwriting, or sales practices; any state coverage requirements for insurance; the application of state antitrust laws to insurance; or any issues related to the capital adequacy of an insurer, except to the extent that such state insurance measure results in less favorable treatment of a foreign insurer than a domestic insurer.
Before determining that a state insurance law should be preempted, the Federal Insurance Office must first notify the affected state and the U.S. Trade Representative that it is considering that the law should be preempted. It then must publish in the Federal Register a notice regarding the preemption or inconsistency with a Covered Agreement, and provide the interested parties opportunity to comment and consider those comments. After determining that preemption is appropriate, the Federal Insurance Office must notify the affected state, the House Ways and Means Committee and Financial Services Committee and the Senate Banking Committee that the law will be preempted. It also must establish a reasonable time period (not less than 30 days) for the preemption to take effect.
Reports to Congress
Beginning on September 30, 2011, and annually thereafter, the Federal Insurance Office must: (i) report to the President and Congress any actions taken to preempt inconsistent state insurance measures and (ii) report to the President and Congress on the insurance industry and provide any additional information requested by Congress. By January 21, 2012, the Federal Insurance Office must report to Congress on how to modernize and improve insurance regulation in the United States. By September 30, 2012, it must report to Congress on the global reinsurance market and by January 1, 2013, it must report to Congress on the ability of state regulators to access reinsurance information for regulating companies in their jurisdictions.
State Insurance Regulation
Surplus Line Insurance
Surplus line, or non-admitted, insurance refers to casualty insurance written by an insurer not licensed in the state in which the policy is written. The policies are placed through surplus line brokers who are specially licensed to produce policies from surplus line insurers.
The Act increases the regulatory prominence of the insured’s “home state,” which is defined as the principal place of business of a commercial insured or the principal residence of an individual insured, unless 100 percent of the insured risk is located outside of that state, in which case it is the state to which the greatest percentage of the insured’s taxable premium for that insurance contract is allocated.4 Under the Act, only the insured’s home state may (i) collect premium taxes on surplus line insurance, (ii) regulate placement of surplus line insurance and (iii) require a surplus line broker to be licensed to procure the insurance. States, however, are free to allocate premium taxes among themselves.
Another goal of the Act is to promote uniform standards for state licensing of surplus line brokers. Effective July 21, 2012, a state is prohibited from collecting licensing fees on surplus line brokers unless it has laws and regulations in effect that provide for participation in the National Association of Insurance Commissioners (NAIC)’s national insurance producer database (or its equivalent). Further, a state is prohibited from establishing eligibility criteria for U.S. surplus line insurers except in conformance with the NAIC Nonadmitted Insurance Model Act. Finally, a state may not prohibit a surplus line broker from placing insurance with a non-U.S. surplus line insurer listed on the NAIC’s Quarterly Listing of Alien Insurers.
The Act also attempts to streamline the application process for commercial purchasers. The Act prohibits a state from requiring a due diligence search for insurance sought by an “exempt commercial purchaser,”5 provided that (i) the surplus line broker has disclosed to the commercial purchaser that the insurance may or may not be available in the admitted market and (ii) the commercial purchaser subsequently has requested in writing that the broker procure or place the surplus line coverage.
Finally, the Act requires the Comptroller of the Currency, in consultation with the NAIC, to study and report to Congress no later than January 21, 2014 on the effect of these reforms on the size and market share of the surplus line insurance market. Specifically, the Act requires the Comptroller to study: (i) changes in the size and market share of the surplus line market and any consequences of those changes; (ii) the extent to which insurance coverage typically provided by the admitted insurance market has shifted to the surplus line insurance market; (iii) the extent to which insurers providing both admitted and surplus lines have seen a shift in volumes between the two lines; and (iv) the extent to which there has been a change in the number of individuals who have surplus line insurance policies, the type of coverage provided under such policies, and whether such coverage is available in the admitted insurance market.
Effective July 21, 2011, the Act’s reinsurance provisions reform how states apply credit for reinsurance and regulate reinsurer solvency.
Credit for Reinsurance
States allow a ceding insurer (the insurer that buys reinsurance) to deduct from its liabilities or add to its assets the ceded reinsurance so long as it meets certain “credit for reinsurance” requirements. Certain states apply their credit for reinsurance requirements on reinsurers that are not domiciled in those states, but are licensed there. The Act prohibits this extraterritorial application of credit for reinsurance if the ceding insurer’s state of domicile is NAIC-accredited, or has substantially similar financial solvency requirements to the requirements necessary for NAIC accreditation, and recognizes credit for reinsurance for the insurer’s ceded risk. The Act preempts other non-domiciliary state laws if they: (i) restrict or eliminate the rights of the ceding insurer or the assuming insurer to resolve disputes pursuant to contractual arbitration; (ii) require that a certain state’s law shall govern the reinsurance contract, disputes arising from the reinsurance contract, or requirements of the reinsurance contract; (iii) attempt to enforce a reinsurance contract on different, inconsistent terms; or (iv) otherwise apply to reinsurance agreements of ceding insurers not domiciled in that state.
Regulation of Solvency
With respect to reinsurer solvency, the Act provides that if the state of domicile of a reinsurer is NAIC-accredited, or has substantially similar solvency requirements, then the state of domicile has exclusive authority to regulate the solvency of the reinsurer, and no other state may require the reinsurer to provide financial information in addition to that provided to its state of domicile.