Fed to push ahead with capital regime for single US insurer

Prudential faces risk capital add-ons unless it sheds “systemically important” label

Fed is sceptical of the activities-based approach

The US Federal Reserve has no intention of scrapping plans for a capital regime applied to systemically important insurers, despite Prudential Financial being the only remaining designated firm, Risk.net understands.

The move intensifies questions over the purpose of the systemically important label for insurers and underscores industry wrangling over the wider regulatory regime for financial institutions.

“The framework is going to go ahead,” says a regulation expert at a US insurer. “There is a general consensus that this is something that should be on the books just in case. It’s important for regulators to have what could be called break-glass powers.”

In June 2016 the Fed issued a formal notice of its plans to create a two-tier capital regime for insurers identified as systemically important, and for insurers that own a bank or savings firm. Under the proposed regime, insurers would have to maintain a liquidity buffer sufficient to meet net cash outflows for 90 days over a range of liquidity stress scenarios.

The rules will apply a “consolidated approach” to the designated firms, whereby capital is calculated by applying risk factors to a group’s consolidated balance sheet. Firms will have to calculate requirements based on a single definition of capital, applying US Gaap to a consolidated balance sheet. This limits the insurer from taking credit for the existing capital it holds according to the differing standards of jurisdictions, both state and international. So an insurance Sifi (systemically important financial institution) will have to carefully manage capital and attempt to satisfy a multitude of minimum thresholds.

Meanwhile the “building block approach” will apply to less complex firms that own a savings unit – also known as a thrift – and aggregate capital across legal entities, taking different capital measures into account.

The Fed’s proposed approach will provide a “crude estimate of risk”, says a report by consultancy Oliver Wyman.

“The approach will limit the sensitivity of the overall framework by ignoring differences in product design that can lead to variations in risk profile,” the report adds.

A timetable for implementing the new capital regime remains elusive. Since June 2016 the Fed has not provided any updates on its plans for a new capital regime for insurers.

Re-designation is always an option but practically no one is really expecting it to be exercised unless something extreme happens

Regulation expert at a US insurer

The designation of US non-bank financial companies as systemically important – and therefore requiring tighter supervision – falls to the Financial Stability Oversight Council, a 10-strong group of domestic heads of supervision. The FSOC also has the power to rescind designations, a decision that requires a two-thirds majority of the council.

Of the original group of four non-bank Sifis, MetLife won a court battle to drop the Sifi tag in 2016, and later the same year GE Capital secured de-designation after halving its assets. The FSOC de-designated AIG the following year, concluding the insurer had sufficiently cut its outstanding debt, derivatives, securities lending, repo and total assets. This left Prudential as the last remaining non-bank Sifi.

But for how long? Global standard-setters are developing a new method of measuring and capitalising systemic risk in the financial system, based on industry-wide risk sources rather than individual entities. The so-called “activities-based approach” could obviate the need for labelling firms as systemically important (see box: Easy as ABA).

The Federal Reserve, though, is sceptical of the value of the activities-based approach, and is likely to press on with its plans for a capital regime for systemically important insurers – even if Prudential sheds its Sifi tag.

The Fed’s logic is that the FSOC could re-designate a firm that had re-risked its balance sheet and reversed its efforts to evade the Sifi label. Other firms could also creep into the designation reckoning. The capital regime would therefore act as a disincentive for such companies to elevate their risk levels.

The council’s powers of designation were under threat from President Trump’s campaign to unwind financial legislation, when he promised to “do a big number” on the Dodd-Frank Act on entering office. But the Crapo bill, which passed the Senate in March this year, did nothing to diminish the powers of the FSOC to designate non-banks as Sifis.

The likelihood of re-designation for AIG and MetLife would increase under new council membership appointed by a Democratic president, sources say.

The Fed declined to comment for this article.

Possible, but unlikely?

The regulation expert at the US insurer says the re-designation of firms that have already been de-designated is technically possible, but it’s not something that many in the industry believe is likely.

“Re-designation is always an option but practically no one is really expecting it to be exercised unless something extreme happens and by extreme I really do mean extreme. Given the political climate there isn’t appetite from the industry to look at thresholds because designation is not really taking up much time as a serious risk,” the expert says.

Comments from the chief of AIG suggest the threat of re-designation will not deter the insurer from its growth plans. On taking up the role of chief executive in May last year, AIG’s Brian Dupperault indicated the group’s post-crisis slimdown was over. “I didn’t come here to break the company up. I came here to grow it,” he said.

It was AIG that precipitated the scrutiny of insurance companies when its ill-fated credit default swap business failed during the financial crisis of 2007–08. The insurer’s London-based unit, AIG Financial Products, issued $2.7 trillion worth of credit default swaps – a form of insurance contract – on risky mortgage-backed securities. When the securities blew up following the US subprime crash, AIG faced huge losses on the swaps. The insurer received a $182 billion bailout from US authorities.

I don’t think it’s a compelling argument to say ‘everyone else has been de-designated so Prudential should be too’

Jeremy Kress, University of Michigan

One academic believes a reformed AIG still presents a risk to the financial system. Jeremy Kress, a professor and senior research fellow at the University of Michigan’s centre for finance, law and policy, adds that Prudential should retain its Sifi tag despite its position as the last designated firm.

“While I disagree with FSOC’s conclusions on AIG’s systemic importance, and think MetLife is still systemically important, if Prudential is the only insurer the FSOC is willing to keep the label on, then they by all means should. I don’t think it’s a compelling argument to say ‘everyone else has been de-designated so Prudential should be too’,” he says.

He is not alone. Others point out that Prudential has made little effort – in comparison to the former non-bank Sifis – to reduce its assets, debt, exposures and systemically risky products.

Prudential Financial declined to comment.

A key consideration for the FSOC when measuring systemic risk is the effect of forced asset liquidation at an individual insurer and its potentially procyclical impact across various markets. Comparing Prudential at the end of 2013 – the year it was designated – with the end of 2017, the insurer’s total assets grew from $732 billion to $832 billion. Across the same period AIG shrank its total assets from $541 billion to $498 billion and MetLife cut down from $887 billion to $720 billion.

FSOC’s justification for designating Prudential in 2013 also focused on the run risk associated with US and international products that have little or no penalty for withdrawal and therefore have the characteristics of short-term liabilities, including variable annuities.

In May this year the insurer said variable annuity outflows would likely accelerate as the US economy grows and interest rates rise. Withdrawals and surrenders increased 23% in the year to March 31, from $2.3 billion to $2.9 billion, demonstrating that the insurer is still exposed to a form of business that regulators consider risky.

Despite this, one source feels it is only a matter of time before Prudential joins rivals AIG and MetLife as an ex-Sifi.

“Prudential is still a non-bank Sifi, but that’s largely related to the types of products they write which are quite specific to them,” says the expert at the US insurer. “I don’t think Prudential is going to remain a Sifi for much longer.”

Easy as ABA

A shift in how regulators assess systemic risk could help persuade a two-thirds majority of FSOC members to de-designate Prudential, potentially keeping insurers out of scope for the Federal Reserve’s capital regime indefinitely.

The development of the activities-based approach (ABA) – an initiative in discussion among global insurance supervisors, the IAIS, that seeks to identify systemic risk across the market as a whole rather than within individual companies – has been met with criticism at some domestic regulators.

Thomas Sullivan, senior adviser for insurance at the Federal Reserve Board, told Risk.net last year he had reservations about the value of the ABA, given that a particular activity may only be identified as systemic once it has precipitated a crisis.

Thomas Sullivan

In a 2017 report, the US Treasury threw its weight behind the ABA. The Financial Stability Board also refrained from publishing a 2017 list of global systemically important insurers (G-Siis). But the IAIS has not abandoned the concept of systemically important firms, and has refused to drop work developing a methodology for designating G-Siis.

Multiple regulation experts at insurers say certain European regulators in particular are against getting rid of entities-based designation in favour of the ABA, including Gabriel Bernardino, chair of the European Insurance and Occupational Pensions Authority.

Jeremy Kress at the University of Michigan says he has co-authored an academic paper, soon to be published, on why the ABA will not help curb systemic risk in the same way as entities-based designation. Considering the near-collapse of AIG in 2008, he says the ABA would not capture the various links between the activities that caused its distress.

“There’s a number of reasons the ABA won’t work, but primarily it’s because a financial institution’s risk profile is a function of all of its activities in the aggregate and how they interact with one another. A purely activities-based approach doesn’t take into account interrelationships and correlations among a firm’s activities,” he says.

“AIG is a great example, it did not fail just because of its credit default swaps, it also failed because it was simultaneously lending securities to third parties and using cash from those counterparties to invest in mortgage-backed securities. The ABA would look at these two activities in isolation and so wouldn’t capture how they interact within a single legal entity.

Editing by Alex Krohn