Lew “comfortable” with Prudential’s SIFI designation, FSOC process & FSOC’s work

Well, the Financial Stability Oversight Council’s (FSOC) hearing over its 2014 annual report is over and done with. Treasury Secretary Jack Lew testified that FSOC has an important, unprecedented job to do, it is doing that job with rigor and transparency, agencies are no longer “siloed,”and that Dodd Frank Act  and its FSOC really shouldn’t be meddled with — except perhaps for technical reasons.

During the June 24 hearing, lawmakers on the House Financial Services Committee pointed out “push back” from the primary regulators on the Council, such as from the independent insurance expert Roy Woodall and from the Securities and Exchange Commission (SEC), on some of the reviews of their sectors’ companies and products.

The lawmakers complained about lack of transparency, the possible avoidance of systemically risky financial institution (SIFI) designations, international capital standards, insurance accounting principles, and how a financial company might be trapped in the label with no way out once it got its SIFI designation, the suggestion that it was not the insurance portion or the state insurance regulators that were at fault with the AIG financial meltdown in a credit default swaps blaze and a variety of problems perceived by their constituents and others with regard to the FSOC process.

After all, the Committee passed two bills last week that put the FSOC on a shorter leash, one a moratorium on SIFI designations for six months and  the other opening up FSOC to the Sunshine Act and the meetings to select members of Congress and federal agency board members.

“I believe the review of the record was a robust one and it warranted the decision,” Lew stated in a reference to Prudential Financial’s SIFI designation last year, after a hearing.  The  decision stands and the company has not appealed it through the courts as it could have, Lew noted. The bar for winning such a court appeal is high, though, the industry has noted.

The FSOC process with Prudential was one that “reflected rigor and analytic quality and I am both comfortable with and concur with the judgment that was made,” Lew said.

Designation is “a big deal” and there is not an opportunity  at all for the potential designee to directly address the final information charges that are used to justify the decision before full FSOC or have the FSOC justify the charges that made their decision, charged  Rep. Gwendolynne  “Gwen” Moore, D-Wis.

Lew said this  was not correct. “There is extensive back and forth between a company and the FSOC ” in the stage three process, Lew said.

Other Committee members  wanted to know what a company could do to fend off stage 3 review, perhaps ditching some of its risky business beforehand, so to speak. Lew said full disclosure before stage 2 might not make sense for the company because it would have to report to financial markets and might affect the company before a decision had been made.

There is a company in Stage 2 now that is an insurer or has large insurance elements, based on a review of the FSOC meeting minutes, which is believed to be Berkshire Hathaway. Bloomberg first reported Berkshire Hathaway may be under FSOC scrutiny in January.

Berkshire Hathaway  sort of passes the criteria for stage 1 of a SIFI if one looks at size. But insurance, although core, is mixed with massive  investments and holdings, including now a major interest in RJ Heinz and  is not 85% of the holding company.  A SIFI must be “predominantly engaged” in financial activities, a US nonbank SIFI “must derive 85% or more of its consolidated annual gross revenues from financial activities or have 85% or more of its consolidated assets related to activities that are financial in nature.”

Of 2013 sated balance sheet revenues, about $36.7 billion were insurance premiums earned, about  $94.8 billion were  in sales ad service revenues, about  $34.8 billion were in  revenues from railroad, utilities and energy businesses, and almost  $16 billion in interest, dividend, investment income, revenue of financial and financial products and derivative gains, all totaled.

Whether it is systemically risky from a reinsurance perspective, even as it appears to be  in stage 2 FSOC analysis, is another question. Warren Buffett wrote in the 2012 annual report AND the 2013 annual report that “if the insurance industry should experience a $250 billion loss from some mega-catastrophe – a loss about triple anything it has ever experienced – Berkshire as a whole would likely record a significant profit for the year because it has so many streams of earnings.”

Indeed, “All other major insurers and reinsurers would meanwhile be far in the red, with some facing insolvency,” Buffet wrote.

Lew  also said once the SIFI designation is made, companies get reviewed once a year. The FSOC chair, said sometimes it will be a product and not a firm that is an issue, and urged lawmakers to let “the process run its course,” and not put FSOC in a place where “you are afraid to ask the question” about whether some company or product is indeed systemically risky.

There are many instances [under review] where there is not a risk and where FSOC does not need to take action, Lew stated. One lawmaker made it seem as if there was a “gotcha” situation with the SIFI designation. He pushed for something called “self-correctness,” something a company can do before it reaches stage 3.

“What?” asked Lew, calling FSOC’s review process of companies very transparent.

As for international accounting and/or capital standards, Lew acknowledged it might be difficult to go about creating them but it was a good thing to “eliminate some of the noise between different systems.”

Lew also told lawmakers that  the goal of going in and amending Dodd -Frank Act was not a good idea on a broader basis,  unless it involved a technical fix (perhaps the reworking Collins Amendment legislation to free Fed-supervised  insurers fro the same minimum capital standers under Basel 3 than the banks).

Lew answered multiple inquiries into the IRS and White House handling of  issues, computer crashes at the White House, cybersecurity  and information-gathering initiatives and other elements of the financial and political system.

 

FSOC annual report testimony on Hill Tues., while FSOC eyeing Stage 2 nonbank, meets in closed session

The Financial Stability Oversight Council (FSOC) will have a busy day Tuesday, June 24, as it meets in a closed, executive session and as Treasury Secretary Jack Lew testified before the House Financial Services Committee (HFSC)  on a hearing  entitled “The Annual Report of the Financial Stability Oversight Council.” Lew will be the only witness.

Although insurance is a subset of FSOC’s realm and of its annual report, there may be questions  from lawmakers on  the prudential regulation by the Federal Reserve of large insurers and asset managers, discussion on the application of domestic and proposed international capital standards and on FSOC’s internal business. HFSC passed measures last week on party line voting, to try and put the brakes on FSOC’s designation process and open it up to more federal officials and Congress.

MetLife is still in stage 3 of its potential designation as a nonbank systemically important financial institution (SIFI.) However, according to a readout of the March 27 FSOC meeting, which was closed, there was a discussion in late March on not only a stage potential designee but also a stage 2 financial company.

MetLife has already acknowledged it is in stage 3 and discussions are likely to continue Tuesday.  Of interest, the company, now stage 2 analysis, is perhaps an insurer or reinsurer.

Although the minutes did not disclose the sector, presentations on the unidentified  company were given by John Nolan, deputy director for Financial Stability in the Federal Insurance Office (FIO), who provided an update on the status of the ongoing analysis of the company. Randall Dodd, senior policy advisor at FIO, Todd Cohen, policy advisor at Treasury; and Scott Alvarez, General Counsel of the Federal Reserve, were available to answer questions on the company. However, the minutes do not reflect any presentation made by the office of the FSOC voting  member with Insurance Expertise, so it could be FIO’s and the Fed’s take on an asset manager with insurance holdings, or perhaps a large reinsurer.

The Financial Stability Board, in concert with the International Association of Insurance Supervisors (IAIS)  is coming out with its reinsurance global systemically important insurers (G-SIIs) around November of this year.  As far as domestics, Berkshire Hathaway could  possibly be among them because of its size, although the percentage of insurance as part of Berkshire Hathaway may not meet specific FSOC threshold material for insurance companies.

The annual report for 2014 again discussed again interest rate risk for insurance companies:

“Despite a significant rise in longer-term interest rates this past year, the insurance industry continued to report investment margins that were below historic averages,” the annual report of FSOC stated.

“If historically low interest rates persist, insurance companies could face a challenge generating investment returns that are sufficient to meet the cash flow demands of liabilities,” the report continued. Interest rates remained well below historical averages and continued to weigh on life insurance investment yields.

Legacy products in particular (including annuities, long-term care, and universal life insurance with secondary guarantees) have been less profitable in the current interest rate environment, as they were originally priced and sold under differing market conditions, as insurers have found out, the report noted.

The current low interest rate environment also may affect the use of captive reinsurance: the low rates affect the present value of insurers’ contract obligations (increasing the present values

of future obligations), and therefore may encourage use of reinsurance for insurance products with liability valuations that are interest-rate-sensitive

FSOC recommends that the Federal Insurance Office (FIO) and state insurance regulators continue to monitor and assess interest rate risk resulting from severe interest rate shocks.

FSOC also reported that Life insurance revenue from insurance and annuity products decreased to $583 billion in 2013 from the record $645 billion set in 2012.

Although  Expanded product distribution channels and a more favorable interest rate environment led to higher fixed annuity sales,  a number of one- time transactions and increased reinsurance cession overcame the improved fixed annuity sales and led to the decrease in total revenues.

Life insurers’ average portfolio yields continued to decline in 2013, but at a slower rate than in 2012, the report stated. Nonetheless, the life insurance sector’s net income rose 6.8% to $41 billion, a record high, benefitting from rising equity markets.

FSOC also delved into concerns regarding captive reinsurance. It pointed out that regulators and rating agencies have noted that the broad use of captive reinsurance by life insurers may result in regulatory capital ratios that potentially understate risk.

During times of financial market volatility when reserve and capital levels for some products should increase, an insurance company that uses captive reinsurance may not be required to hold higher reserves and capital. This could become a financial stability concern if a large, complex insurance organization were to experience financial distress,” the annual report stated.

The concerns have some offsets: The implementation of principles-based reserving (PBR) by the states  may eliminate the need to use captive reinsurance for the purpose of reducing reserves that are significantly higher than expected losses, according to the report.

The Federal Reserve  issued a “Supervision and Regulation Letter” (SRL)  in December 2013 concerning the effects of risk transfer activities on capital adequacy, which would apply to captive reinsurance risk transfer transactions for insurance companies it supervises when they become subject to the Federal Reserve’s risk-based capital framework.

The FIO is still monitoring both the role and impact of captives in the sector and the potential for regulatory improvements at the state level, as well.

Property/Casualty sector revenue from insurance products increased 3.9% to $544 billion in 2013, a record high.

Rates charged by insurers to policyholders increased moderately in most commercial lines of P/C business led by strong sales of workers’ compensation and demand for personal auto insurance. Net income increased to a record level of $70 billion, or an increase of 91.5% from 2012, as expenses and losses paid on claims declined and there were no major storms during the hurricane season in 2013, the annual report stated.