SUMMARY. June 7, 2016

Transcription

1 Federal Reserve Proposes Regulatory Capital Frameworks for Supervised Insurers and Enhanced Prudential Standards for Insurers Designated as Systemically Important FRB Issues Advance Notice of Proposed Rulemaking Describing Two Regulatory Capital Frameworks for FRB-Supervised Insurance Companies; Also Issues Proposed Rule Applying Enhanced Prudential Standards to FSOC-Designated Insurance Companies SUMMARY Proposed Insurance Capital Frameworks On June 3, 2016, the Board of Governors of the Federal Reserve System ( FRB ) unanimously approved an advance notice of proposed rulemaking ( ANPR ) 1 describing two potential regulatory capital frameworks that would apply to two types of FRB-supervised insurers: (1) nonbank financial companies with significant insurance activities that have been designated as systemically important ( Insurer SIFIs ) by the Financial Stability Oversight Council ( FSOC ) pursuant to Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ), 2 and (2) smaller, less complex bank holding companies ( BHCs ) and savings and loan holding companies ( SLHCs ) significantly engaged in insurance activities ( IDIHCs ). 3 The ANPR does not address the regulatory capital treatment by BHCs that are not IDIHCs of assets and liabilities associated with their insurance subsidiaries. The first capital framework, referred to as the building block approach and intended for the IDIHCs, would use, as a starting point, existing state and foreign risk-based capital requirements for insurance company subsidiaries and the FRB s bank risk-based capital standards for banking, non-insurance and New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 unregulated subsidiaries. A firm s aggregate capital requirement would equal the sum of the capital requirements at each subsidiary, with adjustments to address items such as differences in accounting and to eliminate inter-company transactions, and scalars to reflect other cross-jurisdictional differences such as differing supervisory objectives and valuation approaches. 4 The second capital framework, referred to as the consolidated approach and intended for the Insurer SIFIs, would categorize an entire insurance firm s assets and insurance liabilities into risk segments, apply appropriate risk factors to each segment at the consolidated level, and then set a minimum ratio of required capital. 5 The consolidated approach would use risk weights and risk factors determined by the FRB to be appropriate for the longer-term nature of most insurance liabilities and would be U.S. GAAPbased, subject to certain adjustments for regulatory purposes. The ANPR presents the two capital proposals as conceptual frameworks and poses several options for further consideration, leaving important elements and many details for future rulemaking, including the specific risk weights, risk segments and capital adequacy ratios to be used under the consolidated approach, the specific scalars to be used in the building block approach, and the definition and potential tiering of qualifying capital under both proposed frameworks. Proposed Enhanced Prudential Standards On June 3, 2016, the FRB also unanimously approved a notice of proposed rulemaking ( NPR ) 6 that would apply certain enhanced prudential standards to Insurer SIFIs, as required by Section 165 of Dodd-Frank. The proposed rule would require Insurer SIFIs to implement risk management, corporate governance and liquidity risk management standards, including: Risk management: Insurer SIFIs would be required to create and maintain an enterprise-wide risk management framework and implement related policies and procedures. Corporate Governance: Insurer SIFIs would be required to establish and maintain a risk committee of the board of directors responsible for the company s risk management policies and framework, and to appoint a chief risk officer and chief actuary. Liquidity Risk Management: The NPR sets forth responsibilities for the board of directors, risk committee and senior management with respect to liquidity risk management, and would require these companies to: produce and regularly update comprehensive enterprise-wide cash-flow projections over short- and long-term horizons; establish, maintain, and periodically test a contingency funding plan for responding to a liquidity crisis, including performing quantitative assessments to identify liquidity stress events and available funding sources; establish and maintain procedures for monitoring collateral, legal entity liquidity risk, and intraday liquidity risk; conduct rigorous and regular liquidity stress testing and scenario analysis under normal and adverse conditions over four stress-testing time horizons: 7 days, 30 days, 90 days and one year; and -2-

3 maintain a liquidity buffer, comprised of highly liquid, unencumbered assets, sufficient to meet net cash outflows over a 90-day period. The NPR does not include quantitative liquidity requirements analogous to those imposed on banks (e.g., the Liquidity Coverage Ratio and Net Stable Funding Ratio), although, as discussed below, the FRB staff has indicated that it is considering whether or not to propose future quantitative liquidity rules for Insurer SIFIs. A company that is an Insurer SIFI on the effective date of the final rule would be required to comply with the NPR s enhanced prudential standards beginning on the first day of the fifth quarter following the final rule s effective date. Any insurance company designated as an Insurer SIFI after the final rule s effective date would be required to comply with the enhanced prudential standards on the first day of the fifth quarter following the date of its FSOC designation. Comment process The FRB has posed 65 discrete questions in the ANPR and NPR on which it seeks comment, some of which are addressed below. Comments on both the ANPR and the NPR are due on August 2, BACKGROUND Dodd-Frank Dodd-Frank gave the FRB supervisory responsibilities for insurance holding companies that control a federally insured bank or thrift (IDIHCs), 7 as well as for insurance holding companies designated as systemically important by the FSOC (Insurer SIFIs). The FRB currently supervises twelve IDIHCs (all of which are SLHCs) and two Insurer SIFIs (Prudential and AIG). According to the ANPR, these FRBsupervised insurers collectively have approximately $2 trillion in assets and represent approximately one quarter of the total assets of the U.S. insurance industry. The ANPR states that, in comparison to the Insurer SIFIs, the IDIHCs tend to have simpler structures, often have an operating company, rather than a holding company, as the top-tier parent, and have a relatively greater U.S. focus in their operations[,] with some operating exclusively in the United States. In addition, some IDIHCs are mutual insurance companies that are not publicly traded and prepare and file their financial statements based on Statutory Accounting Principles ( SAP ) 8 rather than U.S. Generally Accepted Accounting Practices ( GAAP ). Section 171 of Dodd-Frank, commonly referred to as the Collins Amendment, requires the FRB to establish minimum leverage and risk-based capital requirements on a consolidated basis for all BHCs, SLHCs, and FSOC-designated nonbank financial companies. 9 Subject to certain exceptions, the Collins Amendment provides that these minimum leverage and risk-based capital requirements may not be less than those established for insured depository institutions under the prompt corrective action regulations implementing Section 38 of the Federal Deposit Insurance Act, regardless of total asset size or foreign financial exposure. In addition, these leverage and risk-based capital requirements may not be -3-

4 quantitatively lower than the generally applicable leverage or risk-based capital requirements in effect on the date of enactment of Dodd-Frank (July 21, 2010). In December 2014, Congress passed the Insurance Capital Standards Clarification Act (the Clarification Act ), which provides that, in establishing the minimum leverage and risk-based capital requirements mandated under the Collins Amendment, the FRB is not required to include (including in any determination of consolidation) entities regulated by a state or foreign insurance regulator to the extent such entities act in their capacity as regulated insurance entities, thereby allowing, as the ANPR notes, the FRB to tailor these minimum capital requirements as they would apply to persons regulated by state or foreign insurance regulators. The Clarification Act further provides that the FRB may not require an IDIHC or Insurer SIFI that is also regulated by a state insurance regulator, and files financial statements utilizing only SAP in accordance with state law, to prepare financial statements in accordance with GAAP. Section 165 of Dodd-Frank directs the FRB to establish enhanced prudential standards for nonbank financial companies designated as systemically important by the FSOC (including Insurer SIFIs) and BHCs with total consolidated assets equal to or greater than $50 billion. These enhanced prudential standards must include risk-based capital requirements and leverage limits, liquidity requirements, risk management requirements, resolution plan requirements, 10 single-counterparty concentration limits, and stress-testing requirements. Section 165 also permits the FRB to establish certain additional enhanced prudential standards, including a contingent capital requirement, enhanced public disclosure requirements and short-term debt limits. The ANPR begins the process of establishing for FRB-supervised insurers the risk-based capital and leverage requirements of the Collins Amendment, a process that is well-advanced and in many respects already has been finalized for banking organizations subject to FRB supervision. Although several of the enhanced prudential standards the FRB is required to apply to Insurer SIFIs under Section 165 are addressed in the NPR, the FRB has yet to issue proposed rulemakings that would be applicable to Insurer SIFIs for other enhanced prudential standards set forth in Section 165 or other sections of Dodd- Frank, including Section 165 requirements relating to stress testing and single counterparty concentration limits, as well as early remediation requirements under Section 166 of Dodd-Frank. As discussed further below, many of the enhanced prudential standards proposed in the NPR are similar to the corresponding rules applicable to covered BHCs under the FRB s Regulation YY. However, as indicated in the FRB open meeting to approve the ANPR and NPR on June 3, 2016 (the Open Meeting ), a stress-testing regime for insurers cannot be established until the capital framework for Insurer SIFIs has been determined, although FRB staff indicated that they have been working relatively concurrently on a proposed stress-testing requirement for Insurer SIFIs (to be put in place once the capital rules have been finalized), as well as single-counterparty concentration limits

5 International Developments Passage of Dodd-Frank and related rulemakings and regulations in the United States have occurred at generally the same time as financial regulatory reform initiatives at the international level, including efforts to reform global insurance regulation and develop group-wide insurance capital frameworks. For example, in the European Union ( EU ), the Solvency II Directive (2009/138/EEC) ( Solvency II ), which became effective on January 1, 2016, includes minimum capital and solvency requirements, governance requirements, risk management and public reporting standards applicable to insurers operating in the EU, as well as group-wide supervision and solvency standards that may be applied to insurance groups headquartered outside the EU that have EU operations. In addition, the International Association of Insurance Supervisors ( IAIS ) is in the process of developing several international capital and supervisory standards that are expected, when finalized, to be implemented by member jurisdictions (including the United States). Standards under development by the IAIS would initially apply to large, internationally active insurance companies categorized as either global systemically important insurers ( G-SIIs ) 12 or internationally active insurance groups ( IAIGs ). As part of its efforts to create a common framework for the supervision of IAIGs, the IAIS began work on a comprehensive, group-wide international insurance capital standard (the ICS ) in 2013 to be applied to both G-SIIs and IAIGs, but it is not expected to be finalized until at least The IAIS has also developed proposals for enhanced capital standards to be applied solely to G-SIIs, including basic capital requirements ( BCR ) applicable to all group activities and, for certain businesses and activities, higher loss absorption capacity requirements ( HLA ). Although the BCR and HLA are more developed than the ICS at present, the IAIS has stated that it intends to revisit both standards following development and refinement of the ICS, and that the BCR will eventually be replaced by the ICS. The IAIS s capital standards and requirements proposed to date have generally been based (as with Solvency II) on a market-adjusted valuation approach, and are predicated on the utilization of comparable accounting standards and practices among the jurisdictions in which G-SIIs and IAIGs operate. Many of the IAIS s proposals for international regulatory capital standards remain controversial within the U.S. insurance industry, and among state regulators and the National Association of Insurance Commissioners ( NAIC ), as well as members of Congress. Indeed, in April 2016, a bill, H.R. 5143, entitled the Transparent Insurance Standards Act of 2016 (the Bill ), was introduced in Congress that would, among other things, establish a series of requirements to be met before the United States may agree to or adopt a final international insurance standard with an international standard-setting organization such as the IAIS or a foreign government. Under the Bill, any final capital standard must be consistent with state capital requirements and, to the extent applicable, the capital requirements for insurance companies supervised by the FRB. -5-

6 PROPOSED INSURANCE REGULATORY CAPITAL FRAMEWORKS The ANPR seeks comment on two regulatory capital approaches that are intended to ensure that FRBsupervised insurers have sufficient capital to (i) absorb losses and continue operations as a going concern under adverse conditions, including under economic, financial and insurance-related stresses (e.g., mortality risks, catastrophic risks, etc.); (ii) serve as a source of strength to any subsidiary depository institutions ; and (iii) mitigate any threats to financial stability posed by the company. The capital standards are intended to take into account the overall risk profile and the size, scope, and complexity of the operations of the supervised companies. The two approaches were previewed by FRB Governor Daniel K. Tarullo in his speech at the NAIC s International Insurance Forum in Washington, D.C. on May 20, 2016 (the Tarullo NAIC Speech ). 13 As described further below, Governor Tarullo commented on the FRB s role in insurance supervision and described certain alternative capital frameworks that the FRB considered, but ultimately rejected. For purposes of determining whether an SLHC has significant insurance activities, the FRB proposes that an SLHC would be subject to the capital requirements intended for IDIHCs (i.e., the building block approach) if the SLHC holds 25% or more of its total consolidated assets in insurance underwriting subsidiaries (other than assets associated with insurance underwriting for credit risk). The ANPR indicates that if a BHC were to meet the definition of an IDIHC, the FRB may need to consider excluding it from Regulation Q and adopting a different capital approach. Further, the FRB proposes to define Insurer SIFIs as those FSOC-designated nonbank financial companies that have at least 40% of total consolidated assets related to insurance activities as of the end of either of the two most recently completed fiscal years, or as otherwise ordered by the FRB. The ANPR does not address capital requirements for insurance operations of BHCs or SLHCs that are not IDIHCs or Insurer SIFIs. A. BUILDING BLOCK APPROACH The first proposed capital framework is called the building block approach (the BBA ). Under this aggregated (as opposed to consolidated) approach, a firm s aggregate capital requirements generally would be the sum of the capital requirements of each subsidiary. The regulatory capital requirements of a firm s regulated insurance company subsidiaries would be determined by referring to the capital rules of the relevant state or foreign insurance regulator of the subsidiary. Likewise, the regulatory requirement for each insured depository institution subsidiary (i.e., bank or thrift) would be determined by the FRB s Regulation Q or under other applicable bank capital rules. The regulatory capital requirements for any other regulated or unregulated subsidiary would also be determined under the FRB s Regulation Q. The BBA would then aggregate the qualifying capital and required capital derived from each subsidiary s applicable capital requirements, subject to certain adjustments (discussed below). The ratio of aggregate qualifying capital to aggregate required capital would represent capital adequacy at the consolidated -6-

7 level. As discussed further below, the ANPR does not provide details on the constituents of qualifying capital (including whether it will be tiered or potentially determined at the consolidated level) or what regulatory capital ratios and triggers will be used at the subsidiary level to determine required capital. The ANPR discusses several adjustments that may be required when calculating the BBA s enterprisewide capital requirement, including: Adjustments to conform or standardize differences in accounting treatment under SAP among different states (e.g., insurance company subsidiaries domiciled in different states may be subject to distinct permitted or prescribed accounting practices), and among SAP and foreign jurisdictions. Adjustments to eliminate inter-company transactions. Adjustments to account for differences in stringency applied by different insurance regulators, which the FRB proposes to address through the use of scalars. The FRB proposes that scalars may also be employed to ensure adequate reflection of the safety and soundness and financial stability goals, as opposed to policyholder protection, that the [FRB] is charged with achieving. The ANPR cites several potential weaknesses of the BBA, including: (1) the potential for regulatory arbitrage due to inconsistencies between jurisdictional capital requirements; (2) vulnerability to double leverage (i.e., when an upstream entity issues debt to acquire equity in a downstream entity); (3) extensive adjustments resulting from accounting for inter-company transactions; (4) the potential complexity involved in determining scalars; and (5) the likelihood of requiring legal-entity level stress tests. In the FRB s view, [t]he strengths of the BBA would appear to be maximized and its weakness minimized were the BBA to be applied to [IDIHCs], which generally are less complex, less international, and not systemically important. Moreover, using the BBA for IDIHCs would not infringe on the Clarification Act s prohibition on requiring certain insurers to prepare consolidated financials under GAAP. With regard to Insurer SIFIs, however, the FRB believes the BBA may not capture the full set of risks these firms impose on the financial system without significant use of adjustments and scalars, thereby negating any potential burden reduction from the approach. The ANPR poses several questions and considerations respecting further development of the BBA. Key considerations, in addition to those described above, include: Whether the BBA is appropriate only for a subset of firms more closely resembling the firms that are currently depository institution holding companies (i.e., the 12 insurance-based SLHCs currently supervised by the FRB), and whether a different approach may be appropriate for larger or more complex IDIHCs. Given the variety of capital ratios and corrective action triggers that may be applicable to an insurer or bank subsidiary under relevant insurance and banking capital rules, what triggering thresholds under the relevant regulatory capital rules applicable to the subsidiary should be used as the baseline capital requirements for the subsidiary. -7-

8 In order to reduce the potential for double leverage, whether to adopt a version of the BBA that would determine a firm s aggregate qualifying capital on a uniform, consolidated basis. Under this approach, required capital would still be determined by aggregating capital requirements of subsidiaries, but a single definition of qualifying capital for the IDIHC would be used and applied on a fully consolidated basis. Whether qualifying capital should be categorized into multiple tiers. B. CONSOLIDATED APPROACH The second proposed capital framework is called the consolidated approach (the CA ). The CA would categorize insurance liabilities, assets, and certain other exposures into risk segments; determine consolidated required capital by applying risk factors to the amounts in each segment; define qualifying capital for the consolidated firm; and then compare consolidated qualifying capital to consolidated required capital. As distinguished from the consolidated capital requirements applicable to BHCs, the CA would use risk weights and risk factors that are appropriate for the longer-term nature of most insurance liabilities. Consolidated GAAP-based financial statements would serve as the foundation for the CA, with adjustments for regulatory purposes. Under the CA, the capital ratio would be equal to the ratio of qualifying capital to risk adjusted exposure. The FRB expects the CA initially to be simple in design, with broad risk segmentation, but suggests that it could evolve over time to have an increasingly granular segmentation approach with greater risk sensitivity. Potential weaknesses of the CA identified in the ANPR include: (1) crude risk segments and thus limited risk sensitivity due to its initially simple design; (2) the substantial analysis required to design risk factors for all the major segments of insurance assets and liabilities; and (3) the possibility that a separate SAPbased version of the CA may need to be developed if the CA were ever to be applied to an IDIHC that only uses SAP. The FRB believes that the CA may be an appropriate regulatory capital framework for Insurer SIFIs in large part because the CA would reduce the opportunity for regulatory arbitrage and the potential for double leverage[,] and could more easily enable stress testing for Insurer SIFIs. The ANPR poses several questions and considerations regarding further refinement of the CA. Key considerations, in addition to those discussed above, include: The definition of qualifying capital and whether qualifying capital should be categorized into multiple tiers. Appropriate risk segmentation (including whether the FRB should use for purposes of the CA the risk segmentation framework set forth in the FRB s proposed Consolidated Financial Statements for Insurance Systemically Important Financial Institutions). 14 The treatment of off-balance sheet exposures, and whether any adjustments to GAAP may be needed to determine the exposure amount for insurance liabilities under the CA. -8-

9 The criteria the FRB should consider in developing the minimum capital ratio, and whether one or more definitions of capital adequacy should be used (e.g., well capitalized and adequately capitalized ). C. OTHER ALTERNATIVE FRAMEWORKS CONSIDERED The FRB considered a number of other, alternative capital frameworks, none of which were deemed to meet the FRB s supervisory objectives. For example, the FRB considered, but ultimately rejected, applying a risk-based capital rule based solely on the FRB s existing capital requirements for banking organizations, 15 as well as an approach that would have entirely excluded insurance subsidiaries from the group-wide capital requirements. 16 Internal stress testing was also rejected as being overly complex, too reliant on internal models, and requiring too many supervisory resources, although the FRB intends to continue to explore internal stress testing in connection with its development of a supervisory stress testing program for FRB-supervised insurers. The FRB also rejected a capital approach based on the Solvency II framework out of concern that it would be incompatible with GAAP and may introduce excessive volatility due to discount rate assumptions. Moreover, a Solvency II approach would involve excessive reliance on internal models, which the FRB believes make cross-firm comparisons difficult and can lack transparency to supervisors and market participants. During the Open Meeting, FRB staff also expressed reservations about using an approach based on capital proposals being developed by the IAIS, including a concern that such proposals employ a market-adjusted valuation framework that could introduce unacceptable volatility. These comments largely echoed the Tarullo NAIC Speech, in which Governor Tarullo described several reasons the FRB is disinclined to base its insurance capital requirements on the current IAIS capital proposals, including insufficient development of the ICS; jurisdictional variations in accounting and valuation; potential reliance on internal models; the provisional character of the BCR and HLA; and use of a method of valuation not in use by U.S. companies and regulators. It is not clear what effect the ANPR will have on the IAIS process. Although it clearly rejects certain key elements of the IAIS approach to insurance capital, it is possible that development of the FRB proposals concurrently with the continuing development of the IAIS capital frameworks will lead to some level of convergence or cross-fertilization. PROPOSED ENHANCED PRUDENTIAL STANDARDS The NPR proposes enhanced prudential standards relating to corporate governance, risk-management, and liquidity risk management that would apply to any FSOC-designated nonbank financial company that has 40% or more of its total consolidated assets related to insurance activities as of the end of either of the two most recently completed fiscal years, or that is otherwise made subject to these requirements by the FRB. The proposed enhanced prudential standards generally build on the Consolidated Supervision Framework for Large Financial Institutions outlined in the FRB s Supervision and Regulation Letter

10 17/Consumer Affairs Letter 12-14, dated December 17, 2012 (the Consolidated Supervision Framework ), which by its terms applies to FSOC-designated nonbank financial companies such as the Insurer SIFIs. Accordingly, subject to receipt of additional details and with some exceptions, the proposed enhanced prudential standards are generally in line with market expectations. A. CORPORATE GOVERNANCE AND RISK MANAGEMENT STANDARDS Other than the proposed rules regarding chief actuaries, the proposed requirements respecting corporate governance, risk committees and risk management are substantively identical to the standards set forth in the FRB s Regulation YY that are applicable to BHCs with total consolidated assets of $50 billion or more. 17 Risk Management Framework. The NPR would require that Insurer SIFIs establish and maintain a risk management framework at the enterprise-wide level that includes policies and procedures for establishing risk management governance and procedures for the company s global operations. Specified types of processes and systems would be required for implementing and maintaining the enterprise-wide risk management framework. Risk Committee. Insurer SIFIs would be required to establish a risk committee of the board of directors to approve and periodically review the company s risk management policies and oversee its risk management framework at the enterprise-wide level. The risk committee would be required to include at least one member with experience in identifying, assessing and managing risk exposures of large, complex financial institutions, and the chair of the risk committee would have to be an independent director. Chief Risk Officer and Chief Actuary. The NPR would require each Insurer SIFI to have a chief risk officer and specifies the minimum responsibilities expected of this officer. In addition, Insurer SIFIs would be required to appoint a chief actuary to ensure an enterprise-wide view of reserve adequacy across legal entities, lines of business and geographic boundaries. Insurer SIFIs that have both property and casualty and life insurance businesses could have a co-chief actuary for each business. The NPR notes that both of the existing Insurer SIFIs already have risk management frameworks and policies in place, as well as chief risk officers and chief actuaries or co-chief actuaries. B. LIQUIDITY RISK MANAGEMENT STANDARDS The liquidity risk management proposals set forth in the NPR build on the Consolidated Supervision Framework and are similar in a number of respects with the liquidity risk management standards applicable to BHCs with total consolidated assets of $50 billion or more, as set forth in the FRB s Regulation YY, 18 including those relating to cash-flow projections, contingency funding plans and internal control requirements. 19 The NPR states that the proposed rules would, however, tailor the standards set -10-

11 forth in the Consolidated Supervision Framework to account for the differences in business models, capital structure, risk profiles, existing supervisory framework, and systemic footprints between bank holding companies and systemically important insurance companies. The key deviation from the liquidity risk management standards applicable to banks is that the proposed rule does not include quantitative liquidity requirements analogous to those imposed on banks (e.g., the Liquidity Coverage Ratio and Net Stable Funding Ratio). FRB staff indicated during the Open Meeting, however, that they continue to analyze the pros and cons of potential future quantitative liquidity rules for the systemic [insurance] firms. The FRB s rationale for imposing the proposed liquidity risk management standards on Insurer SIFIs rests on the assumption that certain insurance contracts that are subject to surrender or withdrawal may create significant unanticipated demands for liquidity, and that activities and liabilities such as securities lending, funding agreements, derivatives and other sources can result in liquidity needs during stress, which could be transmitted to the broader economy through the sale of financial assets in a manner that could disrupt the functioning of key markets or cause significant losses or funding problems at other firms with similar holdings. The NPR defines liquidity risk as the risk that a systemically important insurance company s financial condition or safety and soundness will be adversely affected by its actual or perceived inability to meet its cash and collateral obligations. Internal control requirements. The proposed rule would require an Insurer SIFI s board of directors, risk committee and senior management to fulfill specified corporate governance and internal control functions relating to liquidity risk management, including, among other requirements: periodic review and approval by the board of directors of the firm s liquidity risk management strategies, policies and procedures, and approval at least annually of the acceptable level of liquidity risk that the firm may assume in connection with its operating strategies; annual review and approval by the risk committee of the firm s contingency funding plan (discussed further below); and quarterly review, reporting and approval by senior management with respect to various liquidity risk management standards and practices. Insurer SIFIs would also be required to establish an independent review function (independent of management functions that execute funding) to review and evaluate the firm s liquidity risk management processes and liquidity stress testing assumptions. Cash flow projections. The NPR would require each Insurer SIFI to produce comprehensive enterprisewide cash-flow projections that project cash flows arising from assets, liabilities and off-balance sheet exposures under short and long-term time horizons, including time horizons longer than one year. Shortterm cash-flow projections would have to be updated daily and longer-term cash-flow projections updated at least monthly. 20 The NPR specifies certain requirements relating to the methodology Insurer SIFIs will need to establish for making these projections. Contingency funding plan. The proposed rule would require each Insurer SIFI to establish and maintain a contingency funding plan designed to respond to a liquidity stress event, identify alternate -11-

12 liquidity sources that could be accessed during stress events, and describe procedures and actions to take to ensure that sources of liquidity are sufficient to fund normal operating requirements during stress events. The proposal does not set a minimum liquidity requirement that would apply to all Insurer SIFIs. Insurer SIFIs would be required to perform quantitative assessments to identify liquidity stress events and assess available funding sources during such events. The contingency funding plans must also include procedures for monitoring emerging liquidity stress events and identifying early warning indicators. The proposal would further require that Insurer SIFIs periodically test the operational elements and methods of their contingency funding plans. Contingency funding plans would require updating at least annually, and more frequently when market or other conditions warrant. Collateral, legal entity and intraday liquidity risk monitoring. The NPR would require Insurer SIFIs to establish and maintain (1) procedures for monitoring assets that have been or are available to be pledged as collateral, (2) policies and procedures for monitoring and controlling liquidity risk and funding needs within and between legal entities, currencies and business lines (taking into account legal and regulatory transfer restrictions between affiliates), and (3) policies and procedures for monitoring the intraday liquidity risk exposure of the firm. Liquidity stress testing and buffer requirements. Insurer SIFIs would be required to conduct liquidity stress tests that span the different types of liquidity events that the company may face, including macroeconomic, sector-wide, and idiosyncratic events, and incorporate potential actions of counterparties, policyholders and other market participants, as well as the effects of collateral posting requirements. Key features of the liquidity stress testing requirements include: Liquidity stress tests to be conducted monthly, or more frequently as required by the FRB; Liquidity stress scenarios must use a minimum of four time horizons: 7 days; 30 days; 90 days; and one year. For stress tests less than the 90-day period, cash-flow sources could not include any sales of assets not eligible for inclusion in the liquidity buffer (discussed below). In all stress tests, separate account and closed block assets would be permitted to be included as cash-flow sources only in proportion to the cash flow needs in those accounts. Discounts to the fair market value of assets used as a cash-flow source in a stress event would be required to account for market volatility and credit risk. Significantly, the proposed rule would not permit Insurer SIFIs to assume, for the purpose of stress testing, that the company or insurance regulators would defer or stay payments under insurance contracts. According to the FRB, [c]rediting stays would be inconsistent with preventing the failure or material financial distress of a systemically important insurance company. Although insurance contracts may permit deferral of payments for up to six months, the FRB considers these to be measures of last resort that Insurer SIFIs would be very hesitant to invoke for reputational reasons. The NPR would further require Insurer SIFIs to maintain a liquidity buffer sufficient to meet net cash outflows for 90 days over the range of liquidity stress scenarios used in the internal stress testing. -12-

13 Although the FRB requires large BHCs to use a 30-day period for the corresponding liquidity buffer requirements set forth in Regulation YY, the FRB believes the 90-day period proposed for Insurer SIFIs is more appropriate given the longer-term nature of their insurance liabilities. Because of inter-company restrictions on the transfer of funds, inter-company transactions would be excluded in the calculation of the required liquidity buffer, and the proposal would place limitations on where the buffer could be held. Assets held at regulated entities could be included in the buffer up to the amount of their net cash outflows as calculated under the internal liquidity stress tests plus any additional amounts that would be available for transfer to the top-tier holding company during times of stress without statutory, regulatory, contractual or supervisory restrictions. The proposal would also require that the top-tier holding company hold an amount of highly liquid assets sufficient to cover the sum of all stand-alone material entity net liquidity deficits. The stand-alone net liquidity deficit of a material entity would be equal to the entity s amount of net stressed outflows over a 90-day planning horizon less the highly liquid assets held at the entity. The type of assets that may be included in the liquidity buffer would be limited to highly liquid, unencumbered assets. The NPR definition of highly liquid assets is tailored to reflect the assets generally held by [Insurer SIFIs] and the 90-day stress test period proposed for [Insurer SIFIs]. As a consequence, the comparable definition applicable to banks under Regulation YY is significantly different than the definition set forth in the NPR. 21 In the NPR, highly liquid assets may include: securities issued or guaranteed by the U.S. Treasury; provided they are investment grade (if applicable), liquid and readily-marketable, and satisfy other specified conditions that vary by category (and excluding any obligations of a financial institution): securities issued or guaranteed by a U.S. government agency (other than the U.S. Treasury), a U.S. government-sponsored enterprise, a non-u.s. sovereign entity, or certain international organizations; general obligation securities of a public sector entity; corporate debt securities; publicly traded common equity shares; and any other assets the Insurer SIFI demonstrates to the satisfaction of the FRB have low credit risk and low market risk and meet other market-based criteria. As with liquidity stress testing, a discount to the fair market value of assets in the liquidity buffer would be imposed to reflect credit risk and market volatility. C. TRANSITION ARRANGEMENTS The FRB has proposed what it terms meaningful phase-in periods for the enhanced prudential standards covered in the NPR. A company that is an Insurer SIFI on the effective date of the final rule would be required to comply with the NPR s enhanced prudential standards beginning on the first day of the fifth quarter following the final rule s effective date. Any insurance company designated as an Insurer -13-

14 SIFI after the final rule s effective date would be required to comply with the enhanced prudential standards on the first day of the fifth quarter following the date of its FSOC designation. * * * Copyright Sullivan & Cromwell LLP

15 ENDNOTES Federal Reserve System, Draft Advance Notice of Proposed Rulemaking, Capital Requirements for Supervised Institutions Significantly Engaged in Insurance Activities (June 3, 2016), available at Prudential Financial, Inc. ( Prudential ) and American International Group, Inc. ( AIG ) are currently the only two Insurer SIFIs. The FSOC initially designated Prudential and AIG as systemically important nonbank financial companies in The FSOC designated a third insurer, MetLife, Inc. ( MetLife ), in December 2014; however, as permitted by Dodd-Frank, MetLife challenged its designation in federal district court and, on March 30, 2016, the district court rescinded the designation. The FSOC has appealed that decision and the appeal is pending. For additional information on this decision, see our memorandum to clients entitled D.C. District Court Rescinds FSOC s Designation of MetLife as Systemically Important (Apr. 7, 2016), available at The ANPR states that the FRB currently supervises 12 IDIHCs, all of which are SLHCs. According to the ANPR, there are currently no BHCs that meet the definition of IDIHC. Federal Reserve System, Board memorandum regarding the advance notice of proposed rulemaking regarding capital requirements for supervised institutions significantly engaged in insurance activities (June 3, 2016), at *2. Federal Reserve System, Federal Reserve Board approves advance notice of proposed rulemaking and approves proposed rule (June 3, 2016), available at Federal Reserve System, Draft Notice of Proposed Rulemaking, Enhanced Prudential Standards for Systemically Important Insurance Companies (June 3, 2016), available at Prior to the enactment of Dodd-Frank, the Office of Thrift Supervision was the primary federal supervisor of SLHCs. SAP refers to the accounting standards that apply to insurance company financial statements that are required to be filed with state insurance regulators. For information regarding the Collins Amendment and the other requirements of Dodd-Frank, see our memorandum to clients entitled United States Adopts Historic Revision of Financial Services Regulation, available at Feb-2012.pdf. The FRB and Federal Deposit Insurance Corporation have issued a resolution plan rule (12 CFR part 243) that by its terms applies to FSOC-designated nonbank financial companies. Prudential and AIG submitted their annual resolution plans in 2014 and Federal Reserve System, Open Board Meeting on June 3, 2016, available at Prudential, AIG and MetLife have all been designated as G-SIIs by the Financial Stability Board in consultation with the IAIS. Daniel K. Tarullo, Member of the Board of Governors of the Federal Reserve System, Insurance Companies and the Role of the Federal Reserve (May 20, 2016), available at Federal Reserve System, Consolidated Financial Statements for Insurance Nonbank Financial Companies, Comment Request (April 25, 2016), available at

16 ENDNOTES (CONTINUED) Such an approach would not recognize the unique risks, regulation, and balance sheet composition of insurance firms. The Board is not aware of any major country that imposes bank capital requirements on insurance firms. The FRB rejected this because, in part, the parent holding company should be a source of capital strength to the entire entity, including to the subsidiary insurance companies and [insured depository institutions]. See 12 C.F.R See 12 C.F.R For additional information, see our memorandum to clients entitled Enhanced Prudential Standards for Large U.S. Bank Holding Companies and Foreign Banking Organizations: Federal Reserve Approves Final Rule Implementing Certain Provisions of Section 165 of the Dodd-Frank Act Increasing Supervision and Regulation of Large U.S. Bank Holding Companies and Foreign Banking Organization (Feb. 24, 2014), available at Large_US_Bank_Holding_Companies_and_Fore.pdf. The proposed requirements on liquidity risk management internal controls, cash-flow projections, contingency funding plans, and collateral, legal entity and intraday liquidity risk monitoring, largely mirror the standards for large BHCs set forth in Regulation YY, aside from certain modifications to address insurance-specific concerns (e.g., cash-flow projections are to include time horizons longer than one year to capture the long-term nature of insurance liabilities). Although the general framework pertaining to liquidity stress testing and liquidity buffers is similar as between the NPR and Regulation YY, there are several important distinctions between them, including: a 90-day, as opposed to 30-day, planning horizon for the liquidity buffer; the treatment of contractual stays, separate accounts and closed blocks in liquidity stress testing; limitations on intra-group transfer of funds for purposes of the liquidity buffer; and the definition of highly liquid assets. According to the NPR, this would not necessitate revisiting actuarial estimates on each update, but the updates would need to roll the cash flows forward and revise assumptions to the extent required by new data or changing market conditions. See 12 C.F.R (b)(3)i), where highly liquid assets only include (1) cash; (2) securities issued or guaranteed by the United States, a U.S. government agency or a U.S. governmentsponsored enterprise; and (3) any other asset that the BHC demonstrates to the satisfaction of the FRB has low credit risk and low market risk and meets certain other market-based criteria. It is to be noted that the NPR does not include cash in the defined set of highly liquid assets. -16-

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