Only a few weeks ago, there was rampant speculation in the financial community that the Financial Stability Oversight Council (FSOC) – the super-group of regulators established by the Dodd-Frank Act to prevent future financial cataclysms – was on the threshold of designating Metropolitan Life as the third insurer (after AIG and Prudential) to be “systemically important.” This would have meant that the Fed would have been able to impose potentially tougher capital and supervisory rules on the company than state insurance regulators currently do.
But the FSOC didn’t act as expected (though it still might). In the meantime, U.S. financial regulators face another related and important challenge regarding the solvency regulation of insurers, especially those with multiple subsidiaries, or “insurance groups.”
The challenge arises from the heavy international pressure being applied to U.S. regulators by their counterparts in the EU and by international insurance supervisors to adopt the approach to regulating insurer solvency scheduled to be implemented in European Union countries in January 2016. That approach will require large, globally and systemically important insurance groups headquartered in the EU, and potentially all insurers there, to be regulated like banks in an important way.
Bank solvency is regulated in Europe, and in the United States, on a “group” basis. This means that regulators ignore the legal separateness of the different entities belonging to the same group and make all parts of a banking enterprise financially responsible for each other. Bank holding companies must act as a “source of strength” for their subsidiaries, while each of the subsidiaries must “cross-guarantee” the obligations of the others. Dodd-Frank reinforces these notions for banks and systemically important non-banks.
The rationale for regulating group capital of banking organizations is pretty clear. The FDIC (technically, the banks that pay premiums to it) and potentially the Treasury are financially responsible for bank losses, and so it makes sense to require each part of a banking group to put up money to cover them before the government must step in.
But insurance companies, even large ones, are different from banks in two important respects, which make insurers much less of a systemic threat if they fail than large banks. Unlike bank depositors, who can run on a moment’s notice (sometimes paying a small penalty), insurance policy holders cannot. They must have claims first and then wait for them to be paid, or in the case of life insurance investment products, there are a variety of restrictions that keep the money from rapidly flowing out, even in a crisis. Furthermore, insurance companies are not nearly as interconnected with the rest of the financial system as are banks (AIG’s non-insurance subsidiary that brought the parent company down was interconnected, but insurance regulators since have watched such activities much more closely, while the derivatives market is far more regulated than it was before Dodd-Frank).
In short, there is no compelling case to regulate insurer capital on a group basis as there is for banks – as even one of the co-authors of Dodd-Frank, former Congressman Barney Frank, testified before the House Financial Services Committee last month.
Unfortunately, there are also dangers in applying the bank regulatory model to insurance. Policy holders have contracts with individual insurance companies, not groups, because the risks of different kinds of insurance are very different. When you buy your auto insurance policy, for example, you rightfully do not expect your premiums to pay for life insurance death benefits, even if your auto insurance company happens to be affiliated in the same group with a life insurer. But if regulators instead could mush the capital of the different entities together for testing their solvency, then neither the auto nor the life insurer would have an incentive to build up capital to protect its policyholders, which would reduce the financial soundness of each part of the enterprise.
It gets worse. Insurance premiums in some lines of insurance – auto and homeowners, for example – are strictly regulated in some states, but there is no rate regulation in Europe. Given rate regulation, if insurance regulators in states with tight controls over premiums knew that federal regulators would blend the capital of different parts of the same insurance group, then these regulators may be tempted to leave solvency worries to the feds while really clamping down on rates, below levels that are actuarially appropriate. Policy holders may be happy in the short run, but in the long run, this prospect undermines the economic function of insurance and would drive insurers out of the states that go this route. In the end, consumers would have fewer insurance options to choose from, and eventually higher rates, while the individual insurers would be financially weaker.
This difference in rate regulation between the United States and Europe alone should put a stop to any serious consideration by U.S. regulators of adopting the EU’s group capital idea – if the major differences between banking and insurance have not already done so.