Commentary: Does FSOC Understand the Business of Insurance?

The Financial Stability Oversight Council (FSOC) designated AIG as a Systemically Important Financial Institution (SIFI) after determining that “material financial distress at AIG could pose a threat to U.S. financial stability.”

One may debate whether AIG should be a SIFI or whether FSOC even had a choice but to designate AIG, but what should concern the insurance industry are the conclusions FSOC reached about the business of insurance and its apparent disregard for the state insurance regulatory system.

At best, FSOC’s written explanation of its decision shows a lack of understanding about insurance and demonstrates the bank-centric bias that many feared. At worst, it is a signal that almost any insurance group could be designated as a SIFI and brought under federal supervision.

FSOC found that AIG’s core insurance business, its life and annuity business and commercial business, “create exposures and liabilities that could affect its policyholders and those of other insurers if material financial distress at AIG leads to a broader loss of confidence across the industry.”

FSOC applied a classic “run on the bank” theory to life insurers. FSOC suggested that, if a life insurance company’s financial condition is bad enough, people will rush to cash in their life insurance policies and surrender their annuities. According to FSOC, this would force the company to quickly liquidate illiquid assets, thereby causing disruption in financial markets.

Under FSOC’s analysis, every life insurer presents a risk to the life insurance industry and financial markets in general. FSOC suggests that any life insurer that gets into financial trouble could cause contagion in the industry. Other life insurers would be confronted with unanticipated early surrenders and financial disaster. If one goes down, they all could go down.

History, however, does not support that view — life insurers have failed without any contagion or runs on other insurers. In large part, this is because insurance regulators have tools to avoid that kind of outcome and the state regulatory system provides for orderly resolution when an insurance company does fail.

FSOC fails to mention the constant monitoring by state insurance regulators of the financial condition of insurance companies and the power regulators have to take preemptive action to avoid exactly the kind of situation FSOC envisions. Capital and surplus requirements, risk-based capital calculations, the prior approval required for the transfer of insurance company assets and other regulatory requirements were not mentioned.

Presumably, FSOC does not believe state regulators will identify troubled companies or take regulatory actions to prevent a run on a life insurance company. The current regulatory system works very well in assuring the solvency of individual insurance companies. If the individual companies are sound, then the insurance business of the group will be sound.

With respect to the commercial market, FSOC’s criticism is that competitors may not be able to readily replace the specialized products AIG writes in the excess and surplus lines market or the capacity it has in the general commercial market.

In 2012, AIG wrote 8.6 percent of the commercial insurance market and together the top 10 insurance groups wrote less than 50 percent of the commercial market. It seems highly unlikely that other insurance companies would not gladly step up and write the business of any company that exits the highly competitive U.S. market.

It would be unfair not to acknowledge that FSOC considered many factors including AIG’s non-insurance activities, but it is the analysis of the insurance business that is troubling and that may signal an interest in bringing parts of the insurance industry under federal supervision.

If it is truly FSOC’s position that the life insurance industry is subject to runs and contagion, will the next step be a determination that the life insurance industry as a whole is systemically risky? Will property and casualty insurance companies that write specialized risks or have significant market share be considered so vital that their failure could harm the U.S. economy?

Michael Nelson

It may be that FSOC has laid the groundwork for many more insurance groups to be designated as SIFIs and regulated by the Federal Reserve.

Michael Nelson is chairman of insurance law firm Nelson Levine de Luca & Hamilton. Based in the firm’s New York office, Nelson represents clients in matters related to insurance, class actions, corporate business practices, antitrust, coverage, compliance and extracontractual litigation. His current work includes engagements in Connecticut, Illinois, North Carolina, South Carolina, Georgia, Pennsylvania, Florida, Delaware, New York and Washington.