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FSOC - designated institutions play such a vital role in the economy that the government officials do not have the option to allow such institutions to fail because of the destructive role the failure would have on the economy. They inject systemic risk into the economy.

Public Policy Analysis & Opinion

The Rock rests on new turf

Financial Stability Oversight Council denies Prudential's appeal and reaffirms systemic risk

By Kevin P. Hennosy

The National Association of Insurance Commissioners (NAIC) threw down the gauntlet before the Financial Stability Oversight Council (FSOC), and the Council did its best Dionne Warwick impression: The FSOC stepped over the NAIC gauntlet and the FSOC decided to just "walk on by."

The Delaware-chartered corporation doing-business-as the NAIC, released a series of statements that decried the FSOC upholding its decision to designate Prudential Insurance Companies as posing systemic risk to economic stability.

By making that designation, the FSOC subjects the insurance giant to a different—and some say heightened—regulatory framework. The FSOC designation does not mean that the company exhibits traits or symptoms of financial weakness.

The FSOC designation means that the failure of such an institution would have a negative impact on the economy.

The designation concept arose from the experience of financial firms that policymakers deemed "Too-Big-To-Fail" or "TBTF." A firm is considered TBTF because its failure would harm large numbers of independent enterprises that had no hand in causing the failure, which, in turn, shocks the economic system and hinders recovery from the shock.

These FSOC-designated institutions play such a vital role in the economy that government officials do not have the option to allow such institutions to fail because of the destructive role the failure would have on the economy. They inject systemic risk into the economy.

During the deregulation-driven collapse in 2008, policymakers were forced to decide in the chaos of a financial panic which firms were laden with systemic risk. Mistakes were made.

The Congress of 2009-2010 decided to create a system that would allow financial regulators to monitor select large firms before trouble became obvious. This monitoring activity would enhance officials' abilities to identify TBTF institutions. In addition, the increased monitoring would provide lead time to discuss anomalies and weaknesses with company management, in a non-chaotic environment. The proposal became law as a provision of the Dodd-Frank Act of 2010, which sought to restore a semblance of law and order to the financial sector.

According to testimony delivered before a Senate Committee in May 2011, by Federal Reserve Chairman Ben S. Bernanke, the FSOC develops and applies:

…more stringent prudential standards for large banking organizations and nonbank financial firms designated by the FSOC. These standards will include enhanced risk-based capital and leverage requirements, liquidity requirements, and single-counterparty credit limits. The standards will also require systemically important financial firms to adopt so-called living wills that will spell out how they can be resolved in an orderly manner during times of financial distress. The act also directs the Federal Reserve to conduct annual stress tests of large banking firms and designated nonbank financial firms and to publish a summary of the results.

The FSOC provision included "non-bank institutions" because the poster-demon for the TBTF concept is the American International Group (AIG).

In 2008 AIG, then "the world's largest insurer," suffered financial collapse—but received the "world's largest 'mulligan'" when the U.S. Treasury pumped $182.3 billion in public money into the company's private coffers.

The Treasury did not lend the money to AIG because it was run by "nice people." It was not. Nor did the Treasury act to save AIG because the company had a reputation for "good behavior." It did not.

The Treasury acted to keep AIG a going concern because, if the insurance holding company failed, commerce would have frozen up across the world in ways that Nosferatu would have found incredible.

Nice people who generally engage in good behavior would have suffered irreparable harm if AIG had reneged on its promises and dumped vast amounts of devaluated assets on numerous markets.

Furthermore, an AIG failure would have blown a hole in the bottom of state budgets for a century or more. The guaranty fund assessments against insurance companies only finance the payment of claims for failed companies. In most states, states provide a 100% deduction for life insurance guaranty fund assessments. Generally insurers may deduct 40% of their property/casualty guarantee fund assessments and recoup the remaining 60% through increasing rates. Either through lost general fund revenue or higher priced insurance, the public pays for insurance company failures. The AIG bailout protected state budgets for decades to come.

Show-me dissent

The NAIC circulated the usual "canned" quotes following the announcement from the FSOC. The NAIC issued a statement which reported that Louisiana Insurance Commissioner and NAIC President Jim Donelon was "deeply troubled." Former Senator Ben Nelson, the NAIC's million-dollar spokes-model, promised that the Delaware-based corporation would "determine the nature and extent of our response," as if it were a choice between economic sanctions or a nuclear exchange.

The only credible response on behalf of state insurance regulation came from Missouri Department of Insurance, Financial Institutions and Professional Registration Director John Huff, who serves as a representative from insurance regulation on the FSOC. Director Huff is a bright young man although he seems to have drawn a deep quaff from the NAIC's tankard of Kool-Aid. He will learn.

Director Huff commented that the FSOC process seems biased toward banking and unfamiliar with insurance. This criticism is something that the FSOC should take to heart.

That said, Director Huff's comments stray from the question before the FSOC: Does the Prudential Group present systemic risk to the economy if it suffers financial trouble? The FSOC did not opine on whether the Prudential Group suffers from financial weakness or is likely to suffer from financial trouble.

The Show-Me-State regulator's statement presents an argument based on the unlikelihood of the Prudential Group suffering financial difficulties; however, the Prudential's financial condition is not at issue.

One has to wonder whether the NAIC drafted the statement that Director Huff tendered. Director Huff's statement is precisely the kind of statement that one would have expected out of a regulator asserting state regulation of AIG in 2007. Too often, the statement boils down to "Be calm—all is well."

Director Huff opined that the FSOC methodology is too banking-oriented: "There appears to be a lack of recognition given to the nature of the insurance business and the authorities and tools available to insurance regulators."

One can only assume that Director Huff refers to the heroic armies of state regulators who used their tools and authority and saved AIG from plunging into a financial abyss! Yes, I am being cruelly sarcastic, again.

Fear and loathing

In reality, state insurance regulators fear and loathe to use their authority…and tools. This observation is never more accurate than when they face a large and complex insurance group.

Let us consider the failure of AIG again—not only because the "world's largest insurer" failed, but because when anyone brings up AIG the veins stick out on the sides of insurance regulators' necks.

Insurance regulators keep conjuring up new excuses for AIG. "It was not an insurance company!" "The insurance companies did not go broke!" Yeah. Sure. Keep trying.

Insurance regulators botched AIG because they feared AIG and loathed even asking the company basic operational questions. Before the "world's largest insurance company" was TBTF, AIG was "TBTR" or "Too-Big-To-Regulate."

Fear of giants

State insurance regulators only lacked nerve, backbone, and commitment to the public interest to take on AIG. They did not lack the jurisdiction.

Under the McCarran-Ferguson Act of 1945—which the Gramm-Leach-Bliley Act of 1999 affirms is still "the law of the land"—state officials hold the charge to regulate the business of insurance. In SEC vs. National Securities, Inc. 393 U.S. 453 (1969), the Supreme Court defined the scope of that regulatory charge in the following terms:

The relationship between insurer and insured, the type of policy which could be issued, its reliability, interpretation, and enforcement—these were the core of the "business of insurance."… Statutes aimed at protecting or regulating this relationship, directly or indirectly, are laws regulating the "business of insurance."

Even if one believes the fantasy that AIG's guarantees on loan defaults were not insurance, the McCarran-Ferguson Act provides officials jurisdiction to regulate all aspects of the relationship between insurer and insured. That relationship includes the "reliability" of insurance products—which AIG Financial Products undermined with every swap transaction.

State regulators did not decry the alleged lack of authority before AIG collapsed. After the fact, state officials developed convoluted stories fantasizing that AIG was not an insurance company.

In the words of Director Huff, the regulators held "authorities and tools" but they did not use them to stop AIG. Regulators never even tried to use their jurisdiction over AIG. State regulators feared AIG, which made the company TBTR, which is the weightiest systemic risk.

Bank run scenario

Director Huff's statement also focuses on the unlikelihood of large insurers suffering a run on the bank scenario. According to the director's assumption, policyholders and annuitants behave as rational actors in the face of insurer insolvency unlike bank or saving and loan depositors, or investors. What's next: Say's Law?

Anyone who worked around insurance or insurance regulation 25 years ago knows the folly of Director Huff's assumption. The failures of First Executive Corp. (Executive Life), Mutual Benefit Life and a rash of life insurance insolvencies that occurred between 1989 and 1993 exhibited the madness of crowds. Once bad news circulates about an insurer, new sales and renewals drop off, and "surrenders" increase—with variation between and among lines of business.

A risk manager concerned about a quarterly bonus or next year's round of promotions will begin the process of moving group coverage the first time a rumor associates an insurer with financial trouble. No one wants to argue technicalities with a boss who wants to know why you refuse to move business away from a "troubled insurer."

Fear and embarrassment ensues to rule the day—fear of what could be lost and embarrassment over making a mistake by picking the company.

The Executive Life insolvency provides an informative and impressive example of how a "bank run scenario" does apply to insurers and how that run tends to spread throughout the sector, once a large carrier fails.

Yes, large numbers of Executive Life annuitants found themselves trapped in the company because their contracts forbade surrenders. Advocates for the company argued until the bitter end that the existence of those annuitants meant that the company was not broke. Nevertheless, when New York and California finally acted to take over the company, it was nothing more than a corporate hulk.

From personal experience, I can assure Director Huff that when the phone calls from those annuitants and policyholders trapped in a failing company find him, he will not enjoy the conversations.

Policymakers should not rely on "no surrender" provisions in order to stave-off FSOC monitoring of institutions that present systemic risk. Such provisions are insufficient to save an insurer from a run, and they undermine public confidence in insurance as a whole.

It is also time for regulators to forgo the old accounting trick of allowing life insurers to carry bonds at par value on their books during economic downturns. This sleight-of-hand worked to forestall the collapse of the banking sector from spreading into the insurance sector during the Great Depression. It's an accounting gimmick that held merit when life insurers sold fixed-premium/fixed-benefit products, but it is fraudulent in a time of investment-oriented policies. The FSOC should review the impact of this accounting oddity upon life insurer results between 2007 and 2012 in order to better understand how the sector survived the crisis.

No guarantee

Do I believe that because the FSOC can designate any large company as presenting systemic risk that we will never have another AIG? No. Nevertheless, after AIG, the country simply cannot trust the several states to regulate these mega-institutions without the addition of national perspective. The old system failed.

The author

Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide Insurance Cos. and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.

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