Source of Weakness: Worrisome Trends in Solvency Regulation of Insurance Groups in a Post-Crisis World

Robert E. Litan

The regulation of insurer financial strength in the United States historically has focused on a fundamental principle: that the premiums and capital of any insurer are meant to pay the claims of that insurer’s policyholders and not to be drawn on to rescue a failing affiliate within the same group. This is a customer-centric approach, based on the individual insurance contract that is issued by a separately capitalized insurer for a specific period of time, in which the premiums charged are regulated based on that issuer’s solvency position and the risk assumed under that contract.

Since the financial crisis, however, international financial bodies, including the EU, have been pressing U.S. policy makers to adopt the EU’s very different approach toward insurance regulation for globally and systemically important insurers, and potentially for all insurers, borrowing from the banking industry the notion of “group capital” regulation. This latter approach ignores the legal separateness of the different entities belonging to the same group and makes all parts of a banking group financially responsible for each other, through the so-called “source of strength” doctrine for holding companies and “cross-guarantee” requirements for bank subsidiaries. In effect, group capital regulation is creditor-centric, and potentially ignores the specifics of individual insurance contracts.

The U.S. Congress also has expanded the scope of the Federal Reserve’s authority to apply one particular aspect of group capital regulation (the “source of strength” doctrine), but only to systemically important insurance groups. So far, the only two insurance groups to receive this designation are AIG and Prudential, although there has been much speculation that Metropolitan Life will be added to the list at some point.

The FSOC’s designation process raises questions of how U.S. regulators will now respond to the heavy international pressure being exerted to have the United States converge its solvency regulation of insurers with the European approach. This essay urges U.S. policy makers to slow this train down and give serious thought to several key issues.

  • First, if the history of international bank capital standards established by the Basel Committee is any guide – as it should be – the rules applied to a limited number of institutions (Basel initially applied only to internationally-active banks) tend to become a template for a much larger number (the Basel approach has since been applied to a larger group of banking organizations). In the insurance arena in particular, the International Association of Insurance Supervisors (IAIS) is currently working on a global solvency standard initially meant to apply by the end of this year only to Globally Systemically Important Insurers (GSIIs), but plans appear to be in place to use that template for a much larger group of insurers, including those in the United States. That is why the current pressure on the United States to adopt European-style group capital regulation for what initially may be a limited number of insurance groups is so significant: over time, it could become the default rule for all insurers and insurance groups in this country.
  • Second, this essay also explains why there are good reasons for not applying a group capital approach to the overwhelming majority of insurers that cannot reasonably be said to present systemic risk to our financial system, and conceivably to insurance groups that have been so designated: they primarily stem from that fact that the businesses of banking and insurance, and specifically the nature of their liabilities, are very different.
  • Third, there is a key difference between the way in which other aspects of the insurance are regulated in the United States and in Europe, as well as in a fundamental difference in regulatory philosophy: while Europe tends to put primary emphasis on preserving insurers and protecting their creditors, the U.S. historically has focused its primary attention on protecting insurance policyholders, while allowing financially troubled insurers to fail – potentially even systemically important ones under the new resolution procedures of the Dodd-Frank Act.[1]

All this means that while group capital regulation may be appropriate for banks, it clearly is not generally appropriate for insurance. U.S. policy makers should keep these distinctions in mind before embracing any European-style insurance solvency regulation for all but U.S.-designated systemically important insurers or groups, either at the behest of financial regulators in the E.U. or international insurance supervisors (IAIS).

[1] See e.g., Sec. 203(e) of the Dodd-Frank Act, which seeks to preserve and apply state law to any insurance company subject to liquidation or rehabilitation under the Act.