United States: Washington's Unprecedented Bid To Supplant State Insurance Regulators

Richard G. Liskov is a Partner in our New York office.

In mid-October, Prudential Financial Inc. dropped its fight against being designated as a systemically important financial institution (SIFI) by the Treasury Department's Financial Stability Oversight Council. When the oversight council in June named Prudential and AIG as SIFIs, it marked the first time in American history that the federal government would directly regulate the solvency of state-licensed insurers as to all lines of insurance. Given the deference that courts are required to give to agency determinations on complicated and technical matters in which judges are hardly expert, Prudential's decision to accede to the Council's designation is not at all surprising.

AIG willingly accepted its SIFI designation but Prudential resisted, filing an unsuccessful administrative appeal before finally surrendering. The oversight council also voted to subject MetLife to intensive scrutiny for possible designation.

SIFI Insurer Requirements Not Yet Final

This unprecedented assertion of power by the U.S. Treasury raises significant questions about federalism and insurance regulation, all of which can be distilled to one overarching concern: Who can best safeguard the solvency of entities insuring million of Americans?

The 2010 Dodd-Frank financial reform law provides for designating certain "systemically important" insurers for enhanced supervision by the Federal Reserve Board. It is unclear what will be required of SIFI-designated insurers. Why? Because the Fed hasn't finalized its proposed rules issued last year for exercising enhanced supervision over nonbank SIFI designees. On Sept. 18, 2013, Fed Chairman Ben Bernanke said the rules will be "tailored" for SIFI insurers, but he gave no specifics.

If the final rules do not clearly differentiate between designated insurance companies and designated banking entities, however, regulatory incoherence and economically debilitating confusion are inevitable. Nothing in the proposed rule requires the Fed to accede to the objections of a state insurance regulator who has principal responsibility for overseeing the financial condition of a designated insurer.

Until the 2008 AIG bailout, the Fed had never regulated the capital levels of a state-licensed insurance company. But assuming that the Fed's final rule doesn't change, the Fed can ignore the views of New Jersey's Department of Banking and Insurance, which has monitored the solvency of Prudential for over a century.

Moreover, without any "tailoring" at all, the Fed has promulgated a final rule requiring stress testing for all nonbank SIFIs, such as Prudential, to begin next year. In its zeal to prevent another AIG bailout, Congress made no exception in Dodd-Frank for state-regulated insurers that the Financial Stability Oversight Council in its wisdom deemed "systemically important." Nor did Congress acknowledge that the panoply of state solvency measures — including periodic on-site examinations, annual risk-based capital calculations, restrictions on investments, conservative statutory accounting rules, annual actuarial opinions and annual independent CPA audits — would be sufficient to safeguard the solvency of even the largest, most significant insurance players.

In a glaring inconsistency, in Title V of Dodd-Frank, the same law that gave the Fed this unprecedented power to regulate large insurers, Congress explicitly provided that the domestic state regulators of U.S. insurers shall have sole power to regulate the reinsurance arrangements of those insurers — crucial arrangements that measure in the billions of dollars annually — and that the state insurance regulator in the "home state" of a person or business shall exclusively regulate surplus line insurers for risks that licensed insurers will not write. Thus, the same law that requires state insurance officials to oversee the solvency of reinsurers and surplus line carriers — with billions of dollars of coverage at stake, affecting more policyholders than even a "SIFI" insurer has — allows the Fed to overrule the views of those same state regulators when measuring the financial condition of SIFI insurers. Congress has also expressly relied on state regulators to oversee the solvency of insurers that offer Medicare-funded prescription drug plans affecting millions of Americans; yet, when it comes to a SIFI insurer, the Fed enjoys paramount power.

One could more easily understand the logic of Dodd-Frank's preference for federal regulation if the law provided that the Fed would supervise the non-insurance operations of a SIFI insurer, with state officials continuing to have final say over the insurance subsidiaries. But neither Dodd-Frank nor the proposed Fed rules carves out any such division of regulatory labor.

Congress and the president wrongly viewed AIG's implosion as the collapse of an insurance company. Yet AIG's meltdown did not result from its insurance subsidiaries massively understating reserves, greatly overpaying claims or up-streaming excessive dividends. The implosion was caused by one AIG unit recklessly trading in credit-default swaps. A report released in June by the Government Accountability Office generally praised the response of state regulators to the financial crisis in preventing insurer insolvencies.

So instead of focusing federal oversight on the non-insurance operations of major players, the Fed will now displace state insurance officials in overseeing the solvency of SIFI carriers. To be sure, state regulators are not perfect, and their failure to impose consistently strict and transparent accounting rules allowed AIG insurance companies to do risky securities lending. But even with the losses caused by that error, none of the AIG operating insurers was close to being rendered insolvent or in financially hazardous condition.

An Uncertain Future

Unless the Federal Reserve Board's rules defer to state regulators' judgment, the insurance-buying public is likely to see the dismaying spectacle of a new set of inexperienced federal regulators disagreeing with state insurance departments with decades of expertise over a major insurers' financial condition. And insurers designated as SIFI are likely to be perceived as gaining the mantle of the Fed's protection to the detriment of fair competition in the insurance marketplace. How those results further public confidence in sound regulation, or promote the consumer's interest, is anyone's guess.

A version of this article was published in the Wall Street Journal on Oct. 21, 2013.

Mr. Liskov was recently quoted on this topic in Best's Review. In addition, he and another partner in Holland & Knight's New York insurance regulatory practice, John Sarchio, co-authored a chapter on international insurance issues for the newest edition of the Appleman on Insurance Law library edition, entitled "U.S. Regulation of the Solvency and Insolvency of Alien Multi-National Insurers." 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.