WASHINGTON — Federal Reserve Gov. Daniel Tarullo offered a preview Friday of the enhanced capital and liquidity requirements that certain insurers will soon face.
In a speech before a conference of the National Association of Insurance Commissioners, a body representing state insurance regulators, Tarullo said that the central bank will consider those standards "in the coming weeks." They would include separate rules for insurers who fall under the Fed's umbrella because they own a bank or thrift as an affiliate and for firms designated as systemically important financial institutions by the Financial Stability Oversight Council.
Tarullo laid out a pair of approaches: a building-block approach to capital requirements for firms that own a bank or thrift, and a consolidated approach for firms designated by the FSOC.
The building-block approach would aggregate both the capital resources and capital requirements across subsidiaries. Effectively, a firm's capital requirements would be the sum of those of its many parts.
"The capital requirement for each regulated insurance or depository institution subsidiary generally would be based on the regulatory capital rules of that subsidiary's lead regulator — whether a state or foreign insurance regulator or a federal banking regulator for depository institutions," Tarullo said. "The regulatory capital requirement for any noninsurance, nonbanking subsidiaries — which at present are relatively minor parts of these firms — would probably be determined under the standardized risk-based capital rules applicable to affiliates of bank holding companies."
Tarullo said that many steps would be necessary to make such a building-block approach workable. For one, the Fed would have to develop a "formula or scalar" that would make different capital requirements form different regulators comparable across the state and federal regulators. Consideration would have to be given to the role of interaffiliate and interstate transactions — not to mention international considerations.
But he said the proposal has advantages as well. The approach "would efficiently leverage existing legal-entity-level regulatory frameworks" and thus represent "a relatively low regulatory burden" for the firms, he said.
The consolidated approach, or CA, for FSOC-designated firms would be similar to the capital rules applied to bank holding companies but would take into account the different risk profiles of insurance products versus banking products.
"As with our capital requirements for bank holding companies, the CA would categorize all of the consolidated insurance group's assets and insurance liabilities into risk segments, apply risk factors to the amounts in each segment, and then set a minimum ratio of required capital comparing the consolidated capital requirements to the group's consolidated capital resources," Tarullo said. "However, the CA would use risk weights or risk factors that are more appropriate for the longer-term nature of most insurance liabilities."
Tarullo said that this approach would "initially be relatively simple in design, with a relatively small number of risk categories" but that could change over time. The approach would also make insurance firms' capital rules "compatible with supervisory stress testing, which — as you all know — is now a central component of our supervisory program."
The two insurance firms that have accepted their designation as SIFIs by the oversight council — Prudential and American International Group — have been anxiously awaiting some indication by the Federal Reserve as to what shape their enhanced regulation would take. MetLife, a third insurance firm to be designated by the council, recently won its lawsuit in U.S. District Court challenging its designation — a decision that will be appealed.
Tarullo's comments likely allay the firms' worst fears that they would be treated identically to similarly sized bank holding companies, but outline a regime that may be more complicated than they would have hoped. He noted that "the compliance costs associated with the CA will be higher than those of the BBA" but added that the enhanced safety that the CA confers makes the additional cost worth it, and that "compliance costs for these firms should be considerably lower than if they had to conform to the bank holding company capital regime."
Tarullo also said that the new rules would include enhanced liquidity rules, which would "likely include internal control requirements, general comprehensive cash flow projections, contingency plans to manage liquidity stress events, and internal liquidity stress testing requirements."
Tarullo said the standards are unlikely to rely primarily on internal models — as insurance companies are seeking — and would not be based on standards being drafted by the International Association of Insurance Supervisors for Global Systemically Important Insurers.
"We are reluctant to rely on internal models for basic regulatory capital requirements, which makes this idea less appealing to us," Tarullo said. "This somewhat provisional character of the [IAIS standard], along with its reliance on a method of valuation not in use by U.S. companies and regulators, mean it does not really fit our need for an approach that can — as a practical matter — be developed and implemented in the relatively near term."
In response to a question from the audience, Tarullo said that he hoped that the international community could learn from the Fed's experience, such that the U.S. rule "will inform some of the work in the IAIS and over time lead to some standards that are able to cut across the particularities of specific jurisdictions."