US Federal Reserve Board Begins the Process of Regulating Insurance Companies

July 27, 2016

Nearly six years after the adoption of Dodd-Frank’s Title I, which provides for the regulation by the Board of Governors of the Federal Reserve System (Board) of non-bank financial companies – such as insurance companies, finance companies and asset managers that are designated as systemically important financial institutions (SIFIs) by the U.S. Financial Stability Oversight Council (FSOC) – the Board, on June 14, 2016, finally proposed rules that would impose enhanced prudential standards on insurance companies that are designated as SIFIs (SIICs) (Proposal).1 On the same day, the Board published an advance notice of proposed rulemaking regarding capital requirements for SIICs and for depository institution holding companies that are significantly engaged in insurance activities (IHCs) (Capital ANPR). This OnPoint discusses issues raised by the Proposal and the Capital ANPR. 

The Dodd-Frank Act’s SIFI designation provisions may require the Board to supervise a variety of large non-bank financial companies for which it has limited supervisory experience. In that regard, the Board noted that it currently supervises two SIICs2 – Prudential Financial, Inc. (Prudential) and American International Group (AIG). The Board had supervised a third SIIC, MetLife, until MetLife’s SIFI designation was invalidated in April 2016.3 The Board also supervises 12 savings and loan holding companies (SLHCs) that are IHCs. 

The Proposal and the Capital ANPR include 65 specific questions for comment by the public. Comments must be submitted by August 17, 2016. This is a critical stage in the development of the Board’s system for regulating SIFIs. It is not difficult to envision the Board releasing the same types of proposals several years from now with regard to asset managers or investment funds. So the seeds of future regulation will be sown in this process, and once established, the concepts and standards will be more difficult to alter. In that vein, insurance companies, finance companies and asset managers should consider commenting as appropriate to impact the future direction of this regulation. 

The Takeaways 

There are certain notable takeaways from the Proposal and the Capital ANPR. First, there is an extensive focus on costs and benefits of the Proposal, seemingly to respond to: (i) Judge Collyer’s decision in the MetLife case that invalidated the FSOC’s SIFI designation of MetLife; and (ii) the judicial trend to analyze reasonableness through the prism of the regulator’s understanding of the overall economic and practical efficacy and impact of an agency’s rule proposal. The Board noticeably devotes significantly more text to discussing the perceived costs and benefits than it has in previous rulemakings, which also provides a wealth of points to address in the comment period. Indeed, any subsequent challenge of a final version of the Proposal may look back to the record created regarding costs and benefits, so now is the time to substantiate that record. 

Second, while the possibility of a run on life insurance policies played a significant part in the designations of Prudential and MetLife as SIFIs by the FSOC, the role suggested in the Proposal is far less obvious and more nuanced. Liquidity is indeed a critical and central theme in the Proposal, but life insurance runs are not identified as the same crucial element at issue in those designations. Indeed, the Proposal would adopt a system of self-identification of liquidity risks. 

It is notable that the Board states that it now regulates (either as SIICs or IHCs) firms with approximately $2 trillion in assets that represent approximately one-quarter of the assets of the U.S insurance industry. Board regulation does not include general oversight of the insurance activities of a company and its subsidiaries, which historically has been left to the states. 

Insurance supervisors, insurance companies and others have argued that because liability structures, asset classes, and asset-liability matching of insurance companies differ markedly from those of a typical bank holding company, the capital framework(s) should be tailored to the business mix and risk profile of SIICs and IHCs. Such industry participants have also contended that leverage limits based on the ratio of equity to total assets – which are an important backstop in a banking regulatory capital framework – may have less value as a risk metric for supervised institutions engaged in significant insurance activities because these limits do not address the different liability structure inherent in the insurance business. The Board asserts that it has heard and is responding to such critiques. 

The Capital ANPR 

The Capital ANPR notes that each of the 12 current IHCs is an SLHC. The Board notes that it is considering applying the Capital ANPR requirements to SLHCs that hold at least 25 percent of their total consolidated assets in insurance underwriting subsidiaries (other than assets associated with insurance underwriting for credit risk). The Board states that, to the extent a bank holding company (BHC) were to meet the definition of an IHC, the Board would need to consider whether to exclude the BHC from the Board’s Regulation Q and instead apply a different approach. 

The Board further suggests that it may seek to define SIICs as: (i) SIFIs with at least 40 percent of total consolidated assets related to insurance activities (as of the end of either of the two most recently completed fiscal years); or (ii) as the Board may otherwise order. The Board indicates that these thresholds could reflect a level of insurance activity that is significant, rather than incidental to a company’s activities. The Board also states that – 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 – the capital framework should be based on U.S. (and not foreign) regulatory and accounting standards. The Board is proposing for comment two different approaches to capital: the building block approach and the consolidated approach. 

Building Block Approach 

Under the building block approach (BBA), a firm’s aggregate capital requirements generally would be the sum of the capital requirements for each subsidiary, based on the regulatory capital rules of that subsidiary’s functional regulator, with the regulatory capital requirements for a regulated insurance underwriting firm being determined by reference to the rules of the appropriate state or foreign insurance supervisor for insurance subsidiaries, or a federal regulator for an insured depository institution. 

The BBA may require consideration of cross-jurisdictional differences. The Board suggests that this may 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. The BBA would need an appropriate scalar for each local regulatory capital regime, and therefore also would need a set of principles for determining those scalars. 

The Board suggests that the benefits of the BBA are that it: (i) relies on existing legal-entity-level regulatory capital frameworks; (ii) could be developed and implemented expeditiously; (iii) involves relatively low regulatory costs and burdens; and (iv) produces regulatory capital requirements that are tailored to the risks of each distinct jurisdiction and line of business of the institution. 

For SIFIs, the Board believes that the BBA may not capture the full set of risks these firms pose to the financial system without significant use of adjustments and scalars, thereby negating any potential burden reduction. The Capital ANPR cites five main concerns regarding the BBA: (i) at the top-tier level, it is an aggregated, not a consolidated, capital framework; (ii) it would not discourage regulatory arbitrage within an institution (due to inconsistencies across jurisdictional capital requirements) and it may be vulnerable to gaming through techniques such as double leverage (where an upstream entity issues debt to acquire an equity stake in a downstream entity); (iii) it would need to account for intercompany transactions, which may result in extensive adjustments; (iv) it would require the Board to determine scalars regarding a large number of state and foreign insurance regulatory capital regimes; and (v) it likely would require legal-entity-level stress tests, presenting challenges to an appropriate reflection of diversification and intercompany risk transfer mechanisms and other transactions. 

To address the double leverage concern, the Board is considering adopting a version of the BBA that would determine an institution’s aggregate qualifying capital position on a uniform, consolidated basis. 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 for supervised institutions and would apply that definition to the institution on a fully consolidated basis. To implement this version of the BBA, the Board would need to develop a definition of consolidated regulatory capital for supervised institutions significantly engaged in insurance activities, including rules to address minority interests. 

The Board indicates that the BBA may not be appropriate for SIICs or for larger or more complex IHCs. 

Consolidated Approach 

The consolidated approach (CA) is another proposed capital framework for IHCs and SIICs. The CA for IHCs would: (i) categorize insurance liabilities, assets and certain other exposures into risk segments; (ii) determine required consolidated capital by applying risk factors to the amounts in each segment; (iii) define qualifying capital for the consolidated firm; and then (iv) compare consolidated qualifying capital to consolidated required capital. The foundation of the CA for SIICs would be consolidated financial information based on U.S. GAAP, with adjustments for regulatory purposes. Application of the CA to IHCs that do not file U.S. GAAP financial statements would require the development of a consolidated approach based on U.S. Statutory Accounting Principles (SAP). 

The key strengths of the CA noted by the Board include the following: (i) it has a simple and transparent factor-based design; (ii) it covers all material risks of IHCs; (iii) it is a fully consolidated framework that has the potential to reduce regulatory arbitrage opportunities and the risk of double leverage; (iv) it would be relatively expeditious for the Board to develop and for institutions to implement, particularly in light of its broad risk segmentation as implemented initially; and (v) it would provide a solid basis upon which to build consolidated supervisory stress tests of capital adequacy for institutions subject to stress testing requirements. Its weaknesses include: (i) the initially simple design of the CA would result in relatively crude risk segments and thus limited risk sensitivity; and (ii) substantial analysis would be needed to design a set of risk factors for all the major segments of assets and insurance liabilities of supervised institutions significantly engaged in insurance activities.

The Board suggests at this point that it appears that the CA may provide the better regulatory capital framework for SIICs.

The Prudential Standards Proposal 

The Proposal contains a corporate governance and risk management standard along with liquidity risk-management requirements. The Proposal would apply to any nonbank financial company that the FSOC has designated as a SIFI and had at least 40 percent of its total consolidated assets related to insurance activities as of the end of either of the two most recently completed fiscal years, or which otherwise has been made subject to these requirements by the Board. AIG and Prudential would be required to comply with the proposed enhanced prudential standards if they are adopted, and subsequently designated SIICs would be required to conform to the new standards on the first day of the fifth quarter following the effective date of the Proposal. 

Corporate Governance and Risk-Management Standard 

The Board proposes to apply enhanced corporate governance and risk-management standards to SIICs that would build on the Board’s consolidated supervision framework for large financial institutions.6 These standards would be applied, however, in a manner that is tailored to account for the business model, capital structure, risk profile, and activities of SIICs, rather than banking activities. Specifically, the Proposal creates responsibilities for a risk committee, chief risk officer and chief actuary to approve and periodically review the risk-management policies of the company’s global operations and oversee the operation of the company’s global risk-management framework. The risk committee would be required to include at least one member with experience in identifying, assessing and managing risk exposures of large, complex financial firms. 

The chief risk officer would be responsible for overseeing: (i) the establishment of risk limits on an enterprise-wide basis and monitoring compliance with such limits; (ii) the implementation of, and ongoing compliance with, the policies and procedures establishing risk-management governance and the development and implementation of the processes and systems related to the global risk-management framework; (iii) management of risks and risk controls within the parameters of the company’s risk control framework, and monitoring and testing of such risk controls; and (iv) reporting risk-management deficiencies and emerging risks to the risk committee. SIICs would also be required to have a chief actuary to ensure an enterprise-wide review of reserve adequacy across legal entities, lines of business and geographic boundaries. SIICs with significant amounts of life insurance and property and casualty insurance business would be required to have co-chief actuaries – one responsible for the company’s life business and one responsible for the company’s property and casualty business. 

Liquidity Risk-Management 

SIICs would be required to implement a number of provisions to manage liquidity risk – that is, the capacity to meet its expected and unexpected cash flows and collateral needs at a reasonable cost without adversely affecting its daily operations or financial condition. In this regard, SIICs would need to: (i) meet key internal control requirements with respect to liquidity risk management; (ii) generate comprehensive cash flow projections; (iii) establish and monitor liquidity risk tolerance; and (iv) maintain a contingency funding plan to manage liquidity stress events when normal sources of funding may not be available. 

Senior management would be responsible for, among other things, key liquidity risk-management functions, and would be required to monitor and address liquidity risks to the company. Before a SIIC could offer a new product or initiate a new activity that could potentially have a significant effect on the SIIC’s liquidity risk profile, senior management would be required to evaluate the liquidity costs, benefits and risks of the product or activity and approve such product or activity. Senior management would also be required, at least quarterly, to: (i) approve the liquidity stress-testing practices, methodologies and assumptions; and (ii) review the liquidity stress testing results. The proposed rule would require a SIIC to maintain an independent review function that meets at least annually to review and evaluate the adequacy and effectiveness of the company’s liquidity risk-management processes, including its liquidity stress test processes and assumptions. The proposed rule would also require that a SIIC establish a methodology for making projections that include all material liquidity exposures and sources. 

Under the proposed rule, a SIIC would be required to maintain a contingency funding plan for responding to a liquidity crisis and identify alternate liquidity sources that the company can access during liquidity stress events. The contingency funding plan should include a quantitative assessment, an event management process, and monitoring requirements. Further, the plan would have to be commensurate with the SIIC’s capital structure, risk profile, complexity, activities, size, and established liquidity risk tolerance. 

The proposed rule would require rigorous and regular stress testing and scenario analysis that incorporates comprehensive information regarding a SIIC’s funding position under both normal circumstances (when regular sources of liquidity are readily available) and adverse conditions (when liquidity sources may be limited or severely constrained). Required stress scenarios would employ a minimum of four time horizons: 7 days, 30 days, 90 days and one year. Discounts to the fair market value of an asset that is used as a cash flow source to offset projected funding would be required in order to help account for credit risk and market volatility of the asset when there is market stress. The discounts would be required to appropriately reflect differences in credit and market volatilities across asset types. For the purposes of stress testing, a SIIC could not assume a delay of payments under insurance contracts, even though many insurance contracts allow insurers to defer payments by up to six months at the election of either the company or its insurance regulator. 

Although the Board requires large BHCs to use a 30-day period, a SIIC would be required to maintain a liquidity buffer sufficient to meet net cash outflows for 90 days over the range of liquidity stress scenarios used in the internal stress testing. The 90-day period is intended to represent an intermediate period between the length of a fast-moving liquidity scenario that transpires quickly over a month or less, and the length of a persistent liquidity scenario that could take longer than a year to resolve. 

The Proposal would limit the type of assets that may be included in the buffer to highly liquid assets that are unencumbered. The Proposal’s definition of highly liquid assets is tailored to reflect the assets generally held by SIICs and the 90-day stress test period proposed for a SIIC.7 Investment-grade corporate debt would also be eligible if the issuer’s obligations have a proven record as reliable sources of liquidity during stressed market conditions. 

To be included as highly liquid assets, all assets other than securities issued or guaranteed by the U.S. Treasury would have to be liquid and readily marketable. To be liquid and readily marketable under the Proposal, the security must be traded in an active secondary market with more than two committed market makers. Highly liquid assets include any other asset that (i) has low credit risk and low market risk, (ii) is liquid and readily marketable, and (iii) is a type of asset that investors historically have purchased in periods of financial market distress during which market liquidity has been impaired. 

To account for deteriorations in asset valuations when there is market stress, the proposed rule also would require a SIIC to impose a discount to the fair market value of an asset included in the liquidity buffer to reflect the credit risk and market volatility of the asset. Discounts relative to fair market value would be expected to appropriately reflect the 90-day forecast period used to calculate the buffer. 


1) Enhanced Prudential Standards for Systemically Important Insurance Companies, 81 Fed. Reg. 38610 (June 14, 2016).
2) Capital Requirements for Systemically Important Insurance Companies, 81 Fed. Reg. 38631 (June 14, 2016).
3) See Dechert OnPoint, MetLife Opinion Turns the Tables on FSOC: Back to the Drawing Board.
4) A separate SAP-based version of the CA would need to be developed for the insurance depository institution holding company population if the CA were ever applied to an insurance depository institution holding company that only uses SAP.
5) The Board notes that it considered a capital approach based on the European Solvency II framework but decided that this was not appropriate for SIICs and IHCs in the United States. Use of a Solvency II-based capital framework would not adequately account for U.S. GAAP and may introduce excessive volatility due to discount rate assumptions. Moreover, use of a Solvency II-based approach would involve excessive reliance on internal models. The Board also considered a regulatory capital framework based on internal stress testing. The Board indicates that such an approach would: rely on internal models; be highly novel and complex; entail a large and lengthy construction project; and require substantial supervisory resources.
6) The Board’s SR 12-17 sets forth a framework for the consolidated supervision of large financial institutions, and has two primary objectives: (i) enhancing resiliency of a firm to lower the probability of its failure or inability to serve as a financial intermediary; and (ii) reducing the impact on the financial system and the broader economy in the event of a firm’s failure or material weakness.
7) Highly liquid assets would include a range of assets, such as “securities backed by the full faith and credit of the U.S. government, and securities issued or guaranteed by a U.S. government-sponsored enterprise if they are investment-grade as defined by 12 C.F.R. Part 1 and the claim is senior to preferred stock, … securities of sovereign entities outside of the U.S., as well as some international organizations, including the Bank for International Settlements, the International Monetary Fund, and the European Central Bank, if the security would have a risk weight below 20 percent under 12 C.F.R. Part 217 or the security is issued by a sovereign entity in its own currency and the [SIIC] holds the security in order to meet its stressed net cash outflows in the sovereign’s jurisdiction.”

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