Financial Stability Oversight Council Issues Third Annual Report; Federal Insurance Office Insight
Apr 30, 2013
At its most recent meeting on April 25, 2013, the Financial Stability Oversight Council unanimously approved its 2013 Annual Report (“Report”), which was developed collaboratively by its members, their agencies and their respective staff members.
To access hyperlinks to the Report and accompanying data, click here.
Pursuant to the Dodd-Frank Act, the FSOC must report annually to Congress on a range of issues, including the FSOC activities, significant financial market and regulatory developments, and potential emerging threats to the financial stability of the United States. The Report must also make recommendations to promote market discipline, maintain investor confidence, and enhance the integrity, efficiency, competitiveness, and stability of U.S. financial markets.
“Our work on financial reform is absolutely essential, as we work to modernize our regulatory framework and make our financial system more stable” said Treasury Secretary Jacob J. Lew. “Members of this Council continue to make a great deal of progress in building a more resilient financial system, and the Council’s annual report informs the public about actions we have taken over the past year, developments in the financial system during that time, and the challenges ahead.”
In this, its third annual Report, the FSOC’s findings and recommendations are organized around seven themes:
- The vulnerability to runs in wholesale funding markets that can lead to destabilizing fire sales;
- The housing finance system that continues to rely heavily on government and agency guarantees, while private mortgage activity remains muted;
- Operational risks that can cause major disruptions to the financial system;
- The reliance on reference interest rates, which recent investigations have demonstrated were manipulated, particularly in the case of the London Interbank Offered Rate (LIBOR);
- The need for financial institutions and market participants to be resilient to interest rate risk;
- Long-term fiscal imbalances, as the absence of bipartisan agreement on U.S. fiscal adjustment has raised questions about whether long-term fiscal problems may be resolved smoothly; and
- The United States’ sensitivity to possible adverse developments in foreign economies.
In the report, the FSOC’s recommendations address the following topics:
- Reforms to address structural vulnerabilities
- Reforms of wholesale funding markets (money market funds, tri-party repo)
- Housing finance reform
- Reforms relating to reference rates
- Heightened risk management and supervisory attention
- Operational risk (cybersecurity, infrastructure)
- Risk of prolonged period of low interest rates
- Capital, liquidity, resolution
- Progress on financial reform
Some of the insurance-related sections of the Report are reprinted below:
On interest rate risk and insurance companies
The FSOC recommends that the FIO and state insurance regulators continue to be vigilant in monitoring the impact of the low interest rate environment on insurance companies and that state insurance regulators continue to ensure that the economic scenarios run by insurance companies are sufficiently robust and appropriately capture interest rate and other economic risks.
The prospect of continued low interest rates for a prolonged period poses a challenge to life insurers seeking to balance investment risks and returns, especially while trying to build capital and expand product offerings
While insurers have responded to the low interest rate environment by decreasing crediting rates, the flexibility to lower these rates is often limited given the guaranteed minimums on many products. Although the life insurance industry has reduced its minimum guarantees over time, products with minimum guarantees still represent a large share of existing life and annuity products outstanding.
Aside from cutting the crediting rates on their insurance products, life insurers have also responded to the low interest rate environment by reducing exposure to, and increasing policyholder fees on, interest-sensitive businesses such as guaranteed investment products, variable annuities, and long-term care insurance. Life insurers also pursued new revenue sources by acquiring businesses in new markets such as Latin America, and by acquiring fee-earning pension and retirement assets. Some life insurers also increased revenue by leveraging their pre-existing real estate and private placement platforms to offer investment opportunities to other institutional investors.
To offset the declining new money yields on their assets, some life insurers increased portfolio duration and marginally increased their allocation to hedge funds, private equity funds, BBB-rated bonds, and commercial mortgage loans over the last few years, though total exposures by life insurers to these assets are generally below peak levels.
In addition to adversely affecting investment returns, the current low interest rate environment affects the present value of life insurers’ contract obligations. As interest rates have decreased, the present values of future obligations have increased. As a result, life insurers have increased reserve levels, adding further downward pressure to reported financial results. Moreover, the increase in reserves can also be attributed to the asset adequacy testing of liquid assets and change in policyholder lapse assumptions at life insurance companies.
The increase in reserves was less of a factor in 2012 than in 2011 as the decline in interest rates slowed. Although life insurers could increase premiums on new products, this response may affect product sales and is likely to lag the accounting impact of reserve increases on existing products. However, premiumrevenues increased in 2012.
Life insurers could also be adversely impacted by a sudden increase in interest rates, which, under Generally Accepted Accounting Principles (GAAP), would increase unrealized losses in insurers’ fixed income portfolios.
Higher interest rates could also entice policyholders to surrender contracts for higher yield elsewhere. Thus, in order to fund contract surrender payments, insurers could be forced to seek other facilities for liquidity or to liquidate fixed income investments just as the market value has declined.
Property and casualty insurers, which sell insurance on homes, cars, and businesses, underwrite products that result in liabilities that are generally much shorter in duration (with the exception of workers’ compensation insurance) as compared to life insurers, and, therefore, are affected less by the low interest rate environment. However, property and casualty insurers continued to be pressured by large catastrophe losses in 2012.
A.M. Best estimates that insured catastrophe losses were $43.0 billion in 2012-down from $44.2 billion in 2011. The high losses were driven by Superstorm Sandy, a post-tropical storm system that struck the most densely-populated areas of the U.S. eastern seaboard in October 2012.
Current estimates suggest that Superstorm Sandy may have caused $25 billion in insured losses, and up to $50 billion in total economic damages. Despite the catastrophe, property and casualty insurers were able to increase net income and statutory capital and surplus
On Interest Rate Risk Management of Insurance Companies
State insurance regulators require an insurer’s appointed actuary to comply with the Actuarial Standards of Practice promulgated by the Actuarial Standards Board. These standards require that insurance companies run a range of scenarios that reflect the variability of the relevant cash flows being tested.
In light of these actuarial standards, most companies currently use an economic scenario generator (such as the economic scenario generator developed by the American Academy of Actuaries) to generate a large number of economic scenarios.
In addition, state insurance regulations traditionally have prescribed seven scenarios for the potential path of interest rates in order to test the ability of insurers’ portfolios to withstand moderate shocks. These scenarios are often called the “New York 7,” since they were established by a 1986 regulation by the then-New York insurance regulator.
The deterministic approach of the New York 7 scenarios differ from those of stochastic scenario models, New York’s requirement to use the seven scenarios for asset adequacy testing was later incorporated into model actuarial and opinion memorandum regulations that were adopted by the various states, and as a result, most U.S. life insurers were subjected to such testing even though they may not have been domiciled or licensed in New York.
Beginning in 2009, the majority of states have amended their actuarial and opinion memorandum regulations to eliminate the prescribed deterministic scenario requirements of the New York 7.
Under the revised regulations, the New York 7 was replaced by a requirement that each insurance company run scenarios (stochastic or deterministic) that provide a wider array of tests of the adequacy of reserves held, given the assets the company currently holds.
A number of states (irrespective of whether they have yet adopted the amended regulation), also continue to require domiciled insurance companies to run the New York 7; other insurance companies also generally run these scenarios as a matter of practice.
On International Insurance Issues
The FIO and state regulators serve on the International Association of Insurance Supervisors (“IAIS”) Executive Committee and other IAIS committees and subcommittees, including the Technical Committee and the Financial Stability Committee (“FSC”). One of the responsibilities of the Technical Committee is to direct the development of the Common Framework for the Supervision of Internationally Active Insurance Groups (“IAIGs”), which will be an integrated, multilateral, and multidisciplinary framework for the group-wide supervision of IAIGs.
Also, through service on the FSC, FIO, state regulators, and the National Association of Insurance Commissioners (“NAIC”) participate extensively in the process of identifying global systemically important insurers (G-SIIs) and the policy measures to be applied to any designated insurer.
The IAIS released a proposed methodology in May 2012 and proposed policy measures in October 2012. As directed by the Financial Stability Board (“FSB”), the IAIS will finalize its list of G-SIIs, methodology, and policy measures in 2013.
In early 2012, the FIO hosted the insurance leadership of state regulators, the European Commission, and the European Insurance and Occupational Pensions Authority to partner in a dialogue and related project. The goal of this project is to increase mutual understanding and enhance cooperation between the European Union (“EU”) and the United States in order to promote business opportunity, consumer protection, and effective supervision.
The steering committee for the project assembled separate technical committees to analyze and compare the EU and U.S. regimes on seven topics:
(1) professional secrecy and confidentiality;
(2) group supervision;
(3) solvency and capital requirements;
(4) reinsurance and collateral requirements;
(5) supervisory reporting, data collection, and analysis;
(6) supervisory peer reviews; and
(7) independent third-party review and supervisory on-site inspections.
In December 2012, the steering committee published an agreed-upon way forward that defines common objectives and initiatives leading to improved convergence and compatibility between the EU and the United States.
Insurance regulators, through the NAIC, continue work on updating the Insurance Financial Solvency Framework. The NAIC adopted the Own Risk and Solvency Assessment (ORSA) Model Law last year to establish the ORSA filing requirement and the Valuation Manual, which will allow states to consider adoption of the Standard Valuation Law to implement principles-based reserving.
The NAIC continues to work on implementation of the revised Credit for Reinsurance Model Law and Regulation and state regulators are implementing the revised Holding Company Model Law and Regulation, including the Enterprise Risk Report, upon adoption by state legislatures.
The FSOC will also continue to monitor relevant domestic and international financial regulatory proposals and developments involving insurance.
On the Consumer Financial Protection Bureau
In January 2013, the Consumer Financial Protection Bureau (“CFPB”) issued mortgage servicing rules containing nine significant requirements. Five of these requirements address servicing of all mortgage loan accounts (including accounts for borrowers that are current or delinquent on their mortgage loan obligations). These include requirements relating to periodic billing statements, interest rate adjustment notices, payment crediting and payoff statements, force-placed insurance restrictions, and procedures for error resolution and information requests.
The mortgage servicing rules also include four sections setting forth additional protections for borrowers who are delinquent on their mortgage loan obligations. These protections include requirements for servicers to engage in early intervention outreach with borrowers, to provide borrowers with servicer personnel that provide continuity of borrower contact and information, to evaluate borrower applications for loss mitigation options pursuant to certain loss mitigation procedures, and to adopt policies and procedures to achieve certain operational objectives. Many of the servicing requirements include an exemption for small mortgage servicers.
On Financial Reform Progress and Developing a Framework for the Supervision of Large, Global Systemically Important Insurers
The FSB, in consultation with the IAIS, is continuing to create a new framework for the identification and effective supervision of large, global systemically important insurers. In addition, the IAIS is continuing to work on an integrated, multilateral, and multidisciplinary framework for the group-wide supervision of internationally active insurance groups (IAIGs), called the Common Framework for the Supervision of Internationally Active Insurance Groups, which is expected to be adopted by 2018.
The FSOC recommends that the FIO, representing the United States, and state insurance regulators, through the NAIC, continue to play their respective roles in international insurance matters.
About the FSOC
The FSOC was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and is charged with three primary purposes:
1. To identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.
2. To promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the U.S. government will shield them from losses in the event of failure.
3. To respond to emerging threats to the stability of the U.S. financial system.
Pursuant to the Dodd-Frank Act, the FSOC consists of ten voting members and five nonvoting members. It convenes the expertise of federal financial regulators, state regulators and an insurance expert appointed by the President.
The voting members are:
- The Secretary of the Treasury, who serves as the Chairperson of the FSOC;
- The Chairman of the Board of Governors of the Federal Reserve System;
- The Comptroller of the Currency;
- The Director of the Bureau of Consumer Financial Protection;
- The Chairman of the Securities and Exchange Commission;
- The Chairperson of the Federal Deposit Insurance Corporation;
- The Chairperson of the Commodity Futures Trading Commission;
- The Director of the Federal Housing Finance Agency;
- The Chairman of the National Credit Union Administration; and
- An independent member with insurance expertise who is appointed by the President and confirmed by the Senate for a six-year term.
The nonvoting members, who serve in an advisory capacity, are:
- The Director of the Office of Financial Research;
- The Director of the Federal Insurance Office;
- A state insurance commissioner designated by the state insurance commissioners;
- A state banking supervisor designated by the state banking supervisors; and
- A state securities commissioner (or officer performing like functions) designated by the state securities commissioners.
The state insurance commissioner, state banking supervisor and state securities commissioner serve two-year terms.
For a list of attendees at the April 25, 2013 meeting, click here.
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