Dodd-Frank and changing collateral requirements are transforming the regulatory dynamic in the US. Kevin McCarty, president of the NAIC, picks his way through the changing regulatory paradigm.
The ﬁnancial meltdown of 2008–2009 was a wake-up call to regulators globally. Banks had laid economies low—and not for the ﬁrst time—but it was hoped that measures brought in over the ensuing years would create greater oversight and preclude another ﬁnancial crisis. The Dodd-Frank Act—a regulatory measure designed to promote accountability and transparency and put an end to the notion of ﬁnancial institutions being too big to fail—was part of the US response.
It was ﬁnalised in 2011, following political wrangling over the scope of the bill, and its extensive remit makes it “the most sweeping regulatory measure introduced since the Great Depression”, said Kevin McCarty, president of the National Association of Insurance Commissioners (NAIC). Its remit covers a host of ﬁnancial institutions, with insurers excluded from much of its purview, but those insurers associated with banks or considered to be ‘systemically signiﬁcant’ will be subject to heightened oversight.
“Insurers also face consolidated supervision under the auspices of the Federal Reserve, which will probably mean that they will face consolidated capital, liquidity and leverage requirements” as a result of the act, said McCarty. This will mean insurers having to take an increasingly consolidated and global approach to regulatory requirements.
Those re/insurers that are deemed to be systemically signiﬁcant by the Financial Stability Oversight Council (FSOC)—and it is not yet clear how many, if any, re/insurers will fall into this category— “will be subject to the Federal Reserve’s heightened supervision and prudential standards”, said McCarty. “In addition, a number of insurers with asset exposures—particularly life insurers with investments in derivatives—will be subject to new regulations as outlined by the Securities and Exchange Commission.” Consideration for systemic signiﬁcance depends upon “the nature, size, scope, concentration or mix of activities of an individual entity and the threat its failure would pose to the ﬁnancial stability of the US”.
In a multi-stage approach, FSOC will ﬁrst consider a company’s ﬁnancial standing, with the “initial threshold of interest being $50 billion in total consolidated assets. Five other metrics are then used to evaluate a ﬁrm’s systemic signiﬁcance, namely: default swaps, derivatives, debt outstanding, leverage and short-term debt ratio”. Further examinations of the company’s individual position involve a more detailed analysis of the company, “taking into account its size, interconnectedness, substitutability, liquidity, leverage and the current regulatory framework. Size is important when considering systemic signiﬁcance, but size in itself is not going to be decisive”.
From these parameters it would seem likely that the number of re/ insurers deemed to be systemically signiﬁcant will be low. Yet the industry continues to face the same level of oversight as that extended to other, riskier, ﬁnancial institutions. As a result, the NAIC and the newly created Federal Insurance Ofﬁce (FIO) have been working with federal agencies to “ensure that any regulation imposed on insurers by virtue of Dodd-Frank recognises the unique nature of our business and the strong national state regulatory system that is already in place”.
“Bearing in mind the fact that Dodd-Frank is meant to be a remedial piece of legislation, the federal regulatory agencies tend to have a broad view of its empowerment and a limited view of its exceptions. It is important for us to impress upon the federal government the unique nature of the insurance model and explain how it differs from the banking and securities sectors,” said McCarty.
"It is important for us to impress upon the government the unique nature of the insurance model and explain how it differs from the banking and other sectors."
“We have faced an uphill battle convincing other regulators that large re/insurers are not systemically risky. The immediate response to the ﬁnancial crisis was: ‘let’s deal with the banking mess’. There must have been a temptation at the Financial Stability Board to subsume insurance to the banking model, given that the banking model is a supervisory approach that they fully understand. However, we would argue that insurance is less leveraged and more diversiﬁed than banking. Our challenge is to relay that fact to the Financial Stability Board and FSOC.”
Asked if he expects the industry to face increased capital requirements on the back of Dodd-Frank, McCarty said that such requirements would not increase industry-wide as a direct result of the act, “but if entities are deemed systemically signiﬁcant there may well be a different answer”. He explained that regulation is too often viewed through a banking lens and as such “regulators tend to look at capital as the solution to everything”.
“The view of many insurance regulators in the US and elsewhere however, is that we really need to look beyond capital at enhanced supervision. We need to examine the role capital played in the crisis critically and consider whether a lack of capital was a contributing factor to the crisis, or whether it was in fact the result of a lack of supervision. Capital tends to be a short-term solution to what is a very complex problem.”
A federal voice
With the introduction of the FIO there may have been some expectation that the US would take a more federated approach to regulation, but as McCarty explained, regulation will remain at the state level. The US regulatory framework is “made consistent nationally through our accreditation process, which includes substantially similar laws regarding solvency regimes and demonstrates that we have the necessary resources and supervisory processes to ensure that we have conﬁdence in US solvency levels”.
As such, the FIO has limited pre-emptive powers; it is, rather, a source of information and expertise for the federal government, McCarty explained. Under Dodd-Frank, the FIO has relatively limited authority, but it will be a “signiﬁcant pulpit”, particularly in the international arena. “Also, its ﬁndings about perceived gaps in the US regulatory regime will be closely watched and they will have a signiﬁcant role to play in the debate regarding what we need to do to enhance the solvency framework in the US. The FIO will be an important voice in the discourse about regulatory change in the US going forward.”
The NAIC has worked closely with the newly created FIO, as a federal voice joining that of the state-wide regulatory community. As McCarty outlined, the NAIC advocated the creation of the FIO, recognising that insurance needed a federal voice and one that had the ear of the secretary of the Treasury. At the same time, the FIO will draw together a repository of information that will further complement that of the NAIC—which hosts the largest ﬁnancial database in the world.
Helping to strengthen the relationship between the NAIC and the FIO—and the voice of the industry generally—will be the close personal and professional relationship enjoyed by McCarty and FIO director, Michael McRaith. McRaith is a former Illinois director of insurance and former secretary treasurer at the NAIC and there is some expectation that McCarty and McRaith will be largely reading from the same hymn sheet as they look to develop US regulatory measures. Nevertheless, there will be a period of transition and “a process of deﬁning the relative roles of our organisations, both domestically and internationally”, said McCarty. He added that McRaith is a ﬁrm believer in the validity of a state-based regulatory approach and that he expects the FIO to approach the regulatory landscape of the US in an overarching manner—one that recognises the strengths of a federated approach.
Asked whether Europe’s Solvency II initiative could beneﬁt from lessons learned through the US federal approach, McCarty was diplomatic. “We are all a product of our history, culture and legal system and I would not pre-suppose that our approach would necessarily be appropriate elsewhere. That said, we would be more than happy to share our experiences, whether that is through the International Association of Insurance Supervisors or anotherbody, and explain how collaboration can improve the regulatory framework. However, every jurisdiction needs to ﬁnd its best ﬁt in terms of supervising its insurance industry.”
Credit where it’s due
Dodd-Frank has been signiﬁcant, but perhaps the most important development to the US re/insurance landscape for Bermuda players has been the credit for reinsurance model law, introduced by Florida and New York in 2011. The passing of the law, which had been discussed as far back as the 1990s, was a “huge achievement”, said McCarty. “Florida and New York have been pioneers in implementing changes to the regulatory environment, encouraged by conditions particular to those markets. Florida’s heavy reliance on Bermuda markets and the state’s close relationship with the Bermuda Monetary Authority—which plays such an important role in providing supervision of a signiﬁcant part of our reinsurance market—have helped drive this innovation.
“Our homeowners’ companies are largely Florida-based and although they have since branched out across the country, their formative years were in the state. As such they understand the critical role played by international reinsurance in the market. In 2007 we looked at ways for us to move forward and modernise reinsurance provision and expand capacity available to Florida. Reduced collateral limits were a response to this. How reduced limits will play out remains to be seen, but they have certainly helped to inform the national debate about reinsurance.”
Such measures also appear to disprove the notion that the US is taking a protectionist approach to its re/insurance sector. As McCarty explained, 85 percent of US reinsurance is non-domestic, despite the current collateral levels.
“Domestic companies were the ones calling for collateral requirements so that they had the ability to pay their claims promptly. Knowing the regulatory strength of jurisdictions such as Bermuda and the UK, we are now better able to relax those rules, but I don’t think the intention was ever protectionism.”
Many of these policy changes will need to be tested in battle. Their ﬁnal form will likely take some years to coalesce, said McCarty. “Reduced collateral limits will be tested over time to see whether they were a prudent measure, but we will only be able to make that determination when claims are made payable. It is an evolutionary process and has been a long time coming, but we need to build conﬁdence across jurisdictions and introduce greater dialogue, coordination and collaboration.”
US, NAIC, Dodd-Frank, regulation, McCarty