Fed governor walks tightrope on insurer capital reserve rules

Fashioning capital requirements for large insurers with a mix of traditional, nontraditional and noninsurance activities presents regulators with challenges, according to a governor of the Federal Reserve.

In remarks prepared for delivery to the Banque de France conference in Paris on Monday, Federal Reserve Gov. Daniel K. Tarullo noted that traditional insurance liabilities “argue for lower capital requirements than might be required for a hypothetical bank holding a similar portfolio of assets.” Life insurance has an “unusually predictable liability pattern,” and property/casualty insurance, while a bit more volatile, has a volatility that isn’t correlated with the broader economy, he said.

But he noted that many life insurers offer wealth and retirement products with account values that “can be withdrawn at the discretion of the policyholder, sometimes with little or no surrender penalty.” That withdrawal option creates the potential for increased claims that could strain a company’s liquidity, he said.

The move of some insurance firms into securities lending, over-the-counter derivatives, and other capital market activities “can work significant changes in the balance sheets of those firms, creating tighter connections to the rest of the financial system,” he said. “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 books of the insurance company are large enough, it then becomes a potential vehicle for transmitting distress at the company to other parts of the financial system.”

Thus far, the federal Financial Stability Oversight Council has designated three U.S. insurers as systemically important financial institutions and thus subject to enhanced oversight by the Federal Reserve Board. American International Group Inc., MetLife Inc. and Prudential Financial Inc. have been declared SIFIs, although MetLife is challenging that designation in court in a case that has yet to go to trial.

The liability side of the balance sheets of insurance companies can vary substantially just as those deemed banks or bank holding companies, said Mr. Tarullo.

“Yet capital regulation currently applicable to insurance companies seems not to make some of the relevant distinctions,” he said. “Traditional capital regulation, with an implicit aim of protecting only conventional policyholders over time, potentially through an orderly insolvency, does not reflect the balance sheet risks I have just described.”

But he added that some recent initiatives, such as the European Union’s Solvency II capital regime, “may not take account of the fact that liability and liquidity risks for genuinely traditional life insurance products are relatively limited compared to those of many other intermediaries. In some respects, Solvency II ignores the strength of conventional insurance funding — that assets can be held for the truly long-term, through multiple business cycles — even as it focuses directly on the fluctuations in asset values that are indeed relevant to many less conventional activities. “

Mr. Tarullo said his comments illustrated the challenges in fashioning capital requirements for large insurance companies with a mix of traditional, nontraditional, and noninsurance activities that are sometimes quite intertwined in particular business lines or subsidiaries.

“Even where these activities are reasonably segregated from one another, some of the policy devices suggested for differential capital treatment may be misplaced,” he said. “For example, deciding on higher capital requirements based solely on whether an activity is ‘nontraditional’ for an insurance company can be inappropriate.” He said that “nontraditional” activity for an insurance company could “embrace everything from the massive derivatives business maintained by the pre-crisis AIG to very sedate businesses outside the financial sphere entirely. In confronting these and similar challenges, I would suggest that a focus on the actual nature of liabilities associated with a firm’s activities provides a good starting point for sound analysis.”