On June 3, 2016, the Board of Governors of the Federal Reserve System (FRB), approved an advance notice of proposed rulemaking (ANPR)1 regarding two potential regulatory capital frameworks for institutions under the FRB’s supervision that are significantly engaged in insurance activities. According to the ANPR, one framework, called the “consolidated approach” (CA), may be more appropriate for insurance non-bank financial companies designated as systemically important (“systemically important insurance companies” or SIIs) by the Financial Stability Oversight Council. The second framework, called the “building block approach” (BBA), may be more appropriate for holding companies that own a federally insured depository institution (IDI) and that engage in significant insurance activities (“insurance depository institution holding companies”).2 Comments on the ANPR are due no later than August 2, 2016. The FRB expects to use these comments to develop a specific proposal, likely based on these two approaches, and to invite public comment on that specific proposal.3
Section 171 of the Dodd-Frank Act, commonly known as the Collins Amendment, requires that the FRB establish minimum risk and leverage capital requirements on a consolidated basis for SIIs and insurance depository institution holding companies. Under Section 171, these minimum requirements may not be less than “the generally applicable” leverage or risk capital requirements that apply to IDIs and may not be quantitatively lower than “the generally applicable” risk and leverage capital requirements that were in effect for insured depository institutions as of July 21, 2010, when Dodd-Frank was enacted. The Insurance Capital Standards Clarification Act of 20144 amended Section 171 to allow the FRB to tailor these minimum capital requirements as they apply to persons regulated by state or foreign insurance regulators.5 Section 171, as amended, would permit the FRB, in establishing minimum consolidated leverage and risk-based capital requirements for SIIs and insurance depository institution holding companies, to exclude state and foreign regulated insurance entities to the extent such entities act in their capacity as regulated insurance entities.
The ANPR rejects an approach that would entirely exclude insurance subsidiaries and apply capital requirements only to the non-insurance parts of the supervised firm. The FRB’s rationale for proposing regulatory capital frameworks that would include state and foreign regulated insurance entities was that:
the parent holding company should be a source of capital strength to the entire entity, including to the subsidiary insurance companies and IDIs. To do this effectively, a consolidated capital requirement must take into account the risks within the consolidated organization, including insurance risks.6
As a result, the ANPR is the first step in the FRB’s development of specific regulatory capital rules on a consolidated basis that will address the risks of state- or foreign-regulated insurance companies’ assets and liabilities. The FRB recently made clear that it would not base a regulatory capital framework for SIIs or insurance depository holding companies on (1) Solvency II, (2) the comprehensive insurance capital standard being developed by the International Association of Insurance Supervisors (IAIS) or (3) the IAIS’s enhanced regulatory and supervisory framework for global systemically important insurers.7 The FRB reiterated in the ANPR its view that a capital framework for SIIs and insurance depository holding companies “should be based on U.S. regulatory and accounting standards and not foreign regulatory and accounting standards in order to best meet the needs of the U.S. financial system and insurance markets while reflecting the risks inherent in the business of insurance.”8
The two capital frameworks proposed in the ANPR would be predominantly risk-based capital frameworks. The ANPR does not specify the extent to which the FRB proposes to apply leverage capital limits (based on the ratio of equity to total assets) to SIIs or insurance depository institution holding companies.
The ANPR requests comments on several fundamental questions, including on:
- whether the ANPR identifies appropriate considerations for evaluating capital frameworks for SIIs and insurance depository holding companies;
- the appropriateness, and advantages and disadvantages, of applying each of the CA and BBA;
- the challenges and benefits to developing, implementing or applying each of the CA and BBA;
- the extent to which the CA or the BBA would be prone to regulatory arbitrage; and
- whether the BBA would be appropriate for only a subset of supervised institutions resembling the twelve firms that currently would be insurance depository institution holding companies.9
We summarize below the CA and BBA and highlight certain specific issues on which the FRB has specifically requested comments.
2. The CA
- The CA is a predominantly standardized risk-based capital framework. According to the ANPR, “[t]he framework should be as standardized as possible, rather than relying predominantly on a firm’s internal capital models. Greater standardization will produce more consistent capital requirements, enhance comparability across firms, and promote greater transparency.”10
- The CA would “categorize insurance liabilities, assets, and certain other exposures into risk segments; determine consolidated required capital by applying risk factors to the amounts in each segment; define qualifying capital for the consolidated firm; and then compare consolidated qualifying capital to consolidated required capital.”11
- An equation expressing the capital ratio to be used in the CA may be summarized as follows:
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- Adjustments to U.S. GAAP. The foundation of the CA would be the SII’s consolidated financials based on U.S. GAAP. For purposes of determining exposure amounts, in some cases GAAP carrying values may require adjustments for regulatory purposes.12 “For example, adjusting insurance liabilities may be necessary in order to include additional, relevant information, such as current assumptions, or to better match the valuation of related assets.”13
- The Numerator of the CA: Qualifying Capital. For the CA—and perhaps also for the BBA—the FRB proposes to develop a definition of consolidated regulatory capital, including rules to address minority interests. The ANPR requested comment on the criteria that the FRB should consider in developing a definition of qualifying capital under the CA and the BBA, respectively.
- The Denominator of the CA: Exposure Amount. “Implementing the CA would require a framework for segmenting balance-sheet assets, balance-sheet insurance liabilities, and certain off-balance-sheet exposures.”14 The ANPR as well as the FRB’s proposed Consolidated Financial Statements for Insurance Systemically Important Financial Institutions15 suggest three segments at a high level:
- balance-sheet assets, including securities and other invested assets, loans and lease financing receivables, trading assets and reinsurance assets;
- balance-sheet liabilities, including, for life insurers, the following segments: future policy benefits roll forward by line of business, policyholder account balances, variable annuities, closed block, and deferred acquisition costs and value of business acquired roll forward by line of business; and
- derivatives and off-balance sheet items.
While the initial version of the CA likely would have relatively crude risk segments and thus limited risk sensitivity, “the CA could evolve over time to become more risk sensitive.”16
- The Denominator of the CA: Risk Factors. Unlike the FRB’s consolidated capital requirements for bank holding companies, “the CA would use risk weights or risk factors that are “more appropriate for the longer-term nature of most insurance liabilities.”17 The FRB noted that:
- “substantial analysis would be needed to design a set of risk factors for all the major segments of assets and insurance liabilities. . . .”18
- “[b]ecause of the different liability structures between insurance companies and banks, some of the applicable insurance risk factors may differ from the analogous risk factors that apply to banks.”19
The ANPR did not indicate the extent to which the FRB would employ the risk factors used in the standardized approach applicable to U.S. banking organizations for (1) securities and other investment assets and (2) derivatives and off-balance sheet items.
- Minimum Ratio. “One or more definitions of capital adequacy (e.g., “well capitalized” or “adequately capitalized”) would be needed for early remediation and other supervisory purposes.”20 The FRB requested comment on the criteria that the FRB should consider in developing the minimum capital ratio under the CA and a definition of a “well-capitalized” or “adequately capitalized” insurance institution.21
- The Consolidated Financial Statements for Insurance Nonbank Financial Companies.22 The FRB recently proposed for comment the collection of information required by reporting form FR 2085: Consolidated Financial Statements for Insurance Nonbank Financial Companies. Decisions made by the FRB with respect to form FR 2085 might have a significant effect on the development of certain aspects of the CA. For example, the adjustments to U.S. GAAP reflected in proposed form FR 2085 or form FR 2085’s segmentation of balance-sheet assets, balance-sheet insurance liabilities, and certain off-balance-sheet exposures might ultimately be reflected in the details of a notice of proposed rulemaking with respect to the CA. The due date for comments on form FR 2085 is June 24, 2016.
3. The BBA
- Definition of “Significant Insurance Activities”. As a threshold matter, the FRB invites comment on the criteria that should be used to determine which institutions under its supervision are subject to regulatory capital requirements that are tailored to the business of insurance.23 For purposes of determining whether a savings and loan holding company (SLHC) or a bank holding company (BHC) has significant insurance activities and should be subject to capital requirements that are tailored to these risks, the FRB is considering retaining the current threshold: the holding company would be subject to the capital requirements if it held 25% or more of its total consolidated assets in insurance underwriting subsidiaries (other than assets associated with insurance underwriting for credit risk).24
- Sum of Capital Requirements. The BBA would aggregate legal-entity-level qualifying capital and required capital: a firm’s capital requirement generally would be the sum of the capital requirements at each subsidiary.25 However, the FRB is considering adopting a version of the BBA that would determine an institution’s aggregate qualifying capital position on a uniform, consolidated basis. Under such an approach, the BBA would continue to draw upon capital requirements set by the local regulators of each legal entity, but would use a single definition of qualifying capital and would apply that definition to the institution on a fully consolidated basis. The FRB’s rationale for developing a definition of qualifying capital for use with the BBA is that it would address the weakness that the BBA could enable the supervised institution to engage in substantial double leverage.26
- Baseline Capital Requirements. The BBA would begin with the baseline capital requirements at each legal entity. The ANPR noted that for state-regulated insurance companies the BBA “could use different triggering thresholds from the state risk-based capital framework (e.g., the Company Action Level, the Authorized Control Level), or some other level”27 and requested comment on the baseline capital requirement that the FRB should use for (1) insurance entities, (2) banking entities and (3) unregulated entities.
- Insurance Subsidiaries. The capital requirement for each regulated insurance subsidiary generally would be based on the regulatory capital rules of that subsidiary’s functional regulator.28 Accordingly, a U.S. insurance company affiliate of a SLHC would generally be able to use the risk-based capital rules applicable to it under applicable state law, which are based on Statutory Accounting Principles (SAP). The use of SAP would in fact be required for an SLHC engaged in the business of insurance regulated by a state regulator and that files financials prepared only in accordance with SAP.29
- IDIs. The regulatory capital requirement for each IDI generally would be determined under the FRB’s existing rules or under other capital rules applicable to IDIs. “For subsidiary IDIs, the BBA could use the minimum common equity tier 1, tier 1, or total risk-based capital requirements under the standardized approach in the [FRB]’s Regulation Q, as well as the tier 1 leverage ratio.”30
- Other Legal Entities. The regulatory capital requirement for any other regulated non-insurance or unregulated subsidiary legal entity would also be determined under the FRB’s existing capital rules applicable to affiliates of bank holding companies.31 According to the ANPR, for unregulated subsidiaries “the BBA could use the risk-based capital or leverage requirements for depository institutions or some other, similarly stringent approach.”32
- SAP Accounting Adjustments. The FRB indicated that the BBA may require accounting adjustments to standardize the accounting practices under SAP. The FRB noted that “[t]he accounting practices for insurance companies can vary from state to state due to permitted and prescribed practices, and can result in significant differences in financial statements between similar entities filing SAP financial statements in different states.”33 The FRB invited comment on:
- how the BBA should account for state regulator-approved or international variances to accounting rules;34 and
- the approaches or strategies that the FRB could use to calibrate the various capital regimes without needing to make adjustments to SAP or the relevant underlying accounting.35
- Intercompany Adjustments and Scalars. The FRB acknowledged that key weaknesses of the BBA included that (1) extensive adjustments would be needed in order to account for intercompany transactions and (2) the FRB would be required to determine a large number of scalars to bring jurisdictional capital frameworks to comparable levels of supervisory stringency. The ANPR requested comment on each of these issues.
- Intercompany Adjustments. The FRB noted that under the BBA, “some intercompany transactions could generate redundancies in capital requirements, while others could reduce the required capital of a legal entity without reducing the overall risk profile of the institution.”36 The BBA would need to account for intercompany adjustments and requested comment on how the BBA should treat intercompany transactions.
- Scalars. According to the ANPR:
The BBA may require consideration of cross-jurisdictional differences. . . . [T]his would be achieved through the use of scalars. Scalars may, for example, be appropriate to account for differences in stringency applied by different insurance supervisors, and to ensure adequate reflection of the safety and soundness and financial stability goals, as opposed to policyholder protection, that the [FRB] is charged with achieving.37
The FRB requested comment on the criteria that should be used to develop scalars for jurisdictions as well as the benefits and challenges created by the use of scalars.