Corporate Counsel
The Metropolitan
National Edition
Volume 22, No. 10
®
www.metrocorpcounsel.com
© 2014 The Metropolitan Corporate Counsel, Inc.
October 2014
Use Of Credit Ratings In Capital Requirements
For Insurers – The Collins “Fix”
Daniel A. Rabinowitz
Kramer Levin Naftalis &
Frankel LLP
The amount of capital that insurers are
required to hold on their balance sheets has
become a regulatory and legislative flashpoint. A convergence of factors over the last
few years – including federal rulemaking
under The Dodd-Frank Wall Street Reform
and Consumer Protection Act, oversight of
“systemically important” financial institutions, ComFrame, NAIC’s group solvency
Section 171 of Dodd-Frank
(the so-called Collins
Amendment) requires federal financial regulators
to impose capital standards on certain financial
firms at least as rigorous
as those applicable to the
individual banks or S&Ls
within those groups.
initiatives and other regulatory activity – is
significantly changing how insurance companies determine the amount of capital they
need and how regulators oversee insurers’
risks and resources.
Among other developments, Section
171 of Dodd-Frank (the so-called Collins
Amendment) requires federal financial
regulators to impose capital standards on
certain financial firms (depository institution holding companies and systemically
important firms) at
least as rigorous as
those applicable to
the individual banks
or S&Ls within those
groups. It has been
suggested that this
would require the
federal regulators to
impose bank-style
Daniel A.
standards on such
Rabinowitz
firms even where the
firm is an insurer – an anomaly, to say the
least, because of the vastly different capital
and liquidity needs of banks and insurers.
Legislation currently pending in Congress would explicitly reject this possibility
and bring some much-needed clarity to this
area. Senate Bill 2270 and its companion
in the House, H.R. 4510, would expressly
permit the federal agencies to exclude
insurers in considering capital requirements
for such diversified firms. This would be
consistent with the original intent of the
Collins Amendment (as stated by Senator
Collins herself) and should encourage the
Federal Reserve to tailor capital standards
accordingly. It also would align the Collins
Amendment more closely with Section 165
of Dodd-Frank, which expressly permits the
Fed to customize regulatory requirements
for firms depending on the nature of their
business. S. 2270 passed the Senate earlier
this year; H.R. 4510 remains pending in the
House.
The pending legislation would theoretically permit the Fed, in determining the
capital adequacy of insurers within larger
financial institutions, to consult traditional
capital tests under state insurance laws, or
even use them as a proxy. Such state-law
rules, most prominently the risk-based
capital (RBC) regime, could be a useful
tool for federal regulators, and accordingly
many in the insurance sector have embraced
the legislation. Many believe that RBC is a
more accurate and appropriate measure for
insurance company capital needs because,
among other things, it measures not only
liquidity risks associated with investments
but also reinsurance, reserves and other
sector-specific aspects of insurance firms.
Allowing the Fed to leverage this regulatory tool would obviate, at least in part,
the need to fit the square peg of insurers
within the round hole of bank regulation.
To this end, the ability to consult insurance
capital standards would be consistent with
the widely held view that insurers per se
do not pose systemic risk to the economy,
while still allowing the Fed to exercise its
mandate to oversee diversified firms that do
pose such risk (or that are depositary institution holding companies within the Fed’s
jurisdiction).
A recent press item (“Insurers’ Capitol Fix Comes with a Catch,” Wall Street
Journal, July 29, 2014), however, cautions
that this seemingly elegant outcome might
not be completely possible due to Section
939A of Dodd-Frank (which limits the use
of credit ratings in Federal regulation), and
that therefore this legislative “fix” for insurance regulation might inadvertently fall
short of its goal.
To illustrate, consider a hypothetical
diversified financial firm that includes
insurers and other types of entities and that
falls within the Fed’s regulatory jurisdiction under Dodd-Frank. In determining
the needed amount of capital for the consolidated firm, the Fed would be required to
impose FDIC- or Basel III-style standards
on the entities within the group that are
banks (and possibly others). In order to
ascribe a component of the firm’s risk to the
group’s insurer(s), the Fed might choose to
consult determinations already made under
state law as suggested above. These determinations could be based, in part, on the
RBC regime.
Such state-based standards might ascribe
Please email the author at drabinowitz@kramerlevin.com with questions about this article.
October 2014
a different degree of risk to certain insurerheld investments from those that would
apply under bank-centric rules. Commentators have observed that part of the reason
for this is that state-imposed RBC rules
base certain capital charges on credit ratings
of individual investments made by insurers.
By contrast, Section 939A of Dodd-Frank
prohibits federal agencies from even referring to rating agencies in their regulations.
Therefore, it is argued, the Fed would not
be able to use a pure state-based approach
and would have to apply the more stringent
federal banking-type capital adequacy tests
in this key area. Under this view, the goal of
insulating insurers from bank-type regulation would be partially frustrated by the
language of Dodd-Frank itself.
Careful consideration of the language of
Dodd-Frank suggests that this may be an
illusory problem, or at least an exaggerated
one – in other words, federal regulators may
be able to refer to state regulatory rules,
even under Section 939A. Admittedly such
provision does require federal agencies to
“remove [from their regulations] any reference to or requirement of reliance on credit
ratings.” However, it is not at all self-evident
The Metropolitan Corporate Counsel It would be ironic if a legislative fix designed to
restore the
Collins Amendment to its
original meaning would
expose insurers to additional risk of being subject
to bank-centric standards.
that the two provisions (Section 939A and
an amended Section 171) cannot coexist
and both be given effect. The fact that the
Fed has the flexibility to exclude insurers
does not necessarily mean that, if the Fed
does include insurers, it may not rely on
or even refer to state-law-based determinations of solvency. In its overhaul of U.S.
financial regulation, Dodd-Frank contains
numerous carve-outs for state-regulated
insurance companies and accommodates
Volume 22 No. 10
the role of state regulators. For instance,
in Dodd-Frank’s provisions on an “orderly
liquidation authority” for resolving failed
financial companies, insolvent insurers
continue to be subject to state-law receivership provisions. In the provisions governing
investments in hedge funds and private
equity funds (the so-called Volcker Rule,
comprising Section 619 and related federal
regulations), key exceptions are extended
to insurance companies. These carve-outs
illustrate a consistent, largely “hands-off ”
approach to insurance, leaving insurance
to be regulated by the states as it has been
historically. Consistent with this approach,
it seems perfectly legitimate for the Fed to
refer to state-law provisions for setting capital requirements for insurers, even though
those state-law provisions refer to credit
ratings in the risk assessment of bonds.
It would be ironic if a legislative fix
designed to restore the Collins Amendment
to its original meaning would expose insurers to additional risk of being subject to
bank-centric standards. While it is unclear
as of this writing what action, if any, the
House will take on this issue in the remainder of this Congress, stakes are high.