At the NAIC’s tenth International Insurance Forum, Daniel K. Tarullo, a member of the Board of Governors of the Federal Reserve System (FRB), outlined the FRB’s plans for

• the capital and liquidity rules for insurance non-bank financial companies designated as systemically important (“systemically important insurers” or SIIs) by the Financial Stability Oversight Council and 
• the capital rules for certain insurance holding companies that own a federally insured bank or thrift (referred to below as savings and loan holding companies, SLHCs).¹

According to Governor Tarullo, the FRB will issue an advanced notice of proposed rulemaking (ANPR) in the coming weeks that will likely contain different methodologies with respect to capital rules for SIIs and SLHCs, respectively. The approach that the FRB will likely propose for comment in the ANPR will be a “consolidated approach” (CA) for SIIs and a separate “building block approach” (BBA) for SLHCs. 

The CA will be a predominantly standardized risk-based capital approach. The foundation of the CA would be the SII’s consolidated financials based on U.S. GAAP. 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.” The CA will, however, be calibrated to reflect key differences between insurers and banks. Governor Tarullo provided scant details of the CA, but noted that the CA would use risk weights or risk factors that are “more appropriate for the longer-term nature of most insurance liabilities.”² A key concern expressed by insurers with respect to any capital or liquidity rules to be developed by the FRB for insurers is that the rules reflect the key differences between insurers and banks. These differences include insurers’ separate accounts, policy loans and closed block assets and liabilities. While Governor Tarullo acknowledged that the Collins Amendment, as modified in 2014,³ permits tailoring, the details of the ANPR will reveal the extent to which the CA addresses that concern.

With respect to SIIs, Governor Tarullo also indicated that the FRB would propose for comment in the coming weeks (1) enhanced corporate governance and risk management standards and (2) enhanced liquidity standards. Like the capital rules to be proposed for SIIs in the ANPR, this proposed rulemaking would implement the enhanced prudential standards required by Section 165 of the Dodd-Frank Act for non-bank systemically important financial institutions.

Key Takeaways for SIIs

The key takeaways from Governor Tarullo’s remarks are as follows:

• The CA’s “predominantly standardized risk-based capital result … enables comparisons across firms without excessive reliance on internal models.”⁴ The FRB’s rejection of a risk-based capital approach relying heavily on internal models is consistent with Governor Tarullo’s view that post Dodd-Frank the Internal Ratings Based approach has “little useful role to play”⁵ in determining the basic capital requirements of the largest banks. 
• The CA initially would be a broad (as opposed to a granular) segmentation of asset classes and insurance liabilities. 
• With respect to enhanced liquidity requirements expected to be proposed for SIIs, these will likely include, among other things, general comprehensive cash flow projections and internal liquidity stress testing requirements. Governor Tarullo characterized the funding structures of traditional insurers as generally much more stable than the funding structures of commercial banks.⁶ No mention was made of a version of the liquidity coverage ratio (LCR) applying to SIIs.
• Governor Tarullo also indicated that he thought it was “worth continuing to explore internal cash flow stress testing as we build the supervisory stress testing program for [SIIs].”⁷

Key Takeaways for SLHCs

• Under the BBA, “a firm’s aggregate capital requirements generally would be the sum of the capital requirements at each subsidiary. 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.”⁸
• Accordingly, a U.S. insurance company affiliate of a SLHC would generally be able to use the risk based capital (RBC) rules applicable to it under applicable state law, which are based on Statutory Accounting Principles (SAP). The use of SAP would in fact be required for an SLHC engaged in the business of insurance regulated by a state regulator and that files financials prepared only in accordance with SAP.
• The regulatory capital requirements for any non-insurance, non-banking subsidiaries would “probably be determined under the standardized risk-based capital rules applicable to affiliates of bank holding companies.”⁹
• The FRB’s supervisory efforts in the case of SLHCs will continue to focus on ensuring that the SLHCs have strong internal controls, effective corporate governance and satisfactory risk identification, measurement and management.

Liquidity Standards for SIIs

Enhanced liquidity requirements for SIIs “will likely include internal control requirements, general comprehensive cash flow projections, contingency plans to manage liquidity stress events, and internal liquidity stress testing requirements.”¹⁰ In the context of enhanced prudential standards applicable to bank holding companies, “internal liquidity stress-testing requirements” provide a view of an individual firm under multiple scenarios, and include assumptions tailored to the specific products and risk profile of that firm. Governor Tarullo did not mention that SIIs would be subject to the LCR or a standardized measure of liquidity adequacy.¹¹
 
International Capital Standards

The FRB’s approach rejects capital standards that have been developed or are under development at the international level -- Solvency II, the comprehensive insurance capital standard (ICS) being developed by the International Association of Insurance Supervisors (IAIS), and the Basic Capital Requirement for G-SIIs released by the IAIS in 2014. Governor Tarullo indicated the FRB is opting not to follow the Solvency II capital requirements framework because the valuation frameworks for insurance liabilities differ starkly from U.S. GAAP and, in the FRB’s view, may introduce excessive volatility; the Solvency II approach is at odds with a standardized risk-based capital rule that enables comparison across firms without reliance on internal models; and the Solvency II rules may be “quite pro-cyclical.”

He further indicated the FRB was unwilling to wait until completion of the ICS and noted progress on its development has been slow and is hampered by heterogeneity among insurance products sold in different countries and differences in accounting and valuation standards, as well as disagreement on extent to which capital standards should be built on internal models. He indicated the FRB also declined to adopt the BCR and Higher Loss Absorbency used for global systemically important insurers (G-SIIs) because it considers them to be provisional in character in that they will need to be revisited after the ICS and work on the G-SII identification methodology is complete, in addition to their reliance on methods of valuation not in use by U.S. companies and regulators.
 
Questions from Regulators

Governor Tarullo answered questions from various insurance regulators present during his speech. Julie McPeak (NAIC Vice President and Commissioner, Tennessee Department of Commerce and Insurance) asked if an alternative approach should be developed for U.S. Internationally Active Insurance Groups and whether it should be aligned with the FRB approaches. In response, Governor Tarullo commented that the IAIS’s work helps identify issues that have to be addressed, but time and complexity are involved in developing appropriate standards and the FRB has a statutory responsibility to move forward and wants an insurance-oriented approach that is relatively simple. He expressed hope that international regulators learn from the FRB, and that such learning could lead to group capital standards that are workable across jurisdictions and that align well with what state insurance departments do.

Bruce Ramge (Director, Nebraska Department of Insurance) asked how states should weigh in, noting that state insurance commissioners do not want variations from the RBC model. In response, Governor Tarullo noted that staff at the FRB and NAIC’s office have good relationships and said he believes there should be an exchange of information for both specific regulated companies and the overall framework. He noted the ANPR process is being used to allow input on the conceptual framework before specific regulations are drafted. He invited regulators to comment individually or through the NAIC.

Dr. Yoshihiro Kawai (IAIS Secretary General) asked if the FRB plans to pursue more risk-sensitive capital requirements in the future. In response, Governor Tarullo emphasized the FRB’s preferred approach is to rely on stress testing. He noted the annual supervisory stress testing for large banks and bank holding companies and explained they will incorporate the SIIs into this process, with appropriate adjustments for insurance assets and liabilities. He said he considers this approach to be risk-sensitive in a way that assures comparability across groups without relying on internal capital models that, in the FRB’s view, allow different banks to have different outcomes form the assessment of the same assets.
                                                  
 
¹ See Daniel K. Tarullo, Governor, FRB, Remarks at the National Association of Insurance Commissioner’s International Insurance Forum: Insurance Companies and the Role of the Federal Reserve 12 (May 20, 2016), available at https://www.federalreserve.gov/newsevents/speech/tarullo20160520a.pdf [hereinafter NAIC International Insurance Forum Speech]. In July 2013, the U.S. banking agencies adopted the U.S. Basel III capital rules. (78 Fed. Reg. 62018 (Oct. 11, 2013)). The agencies excluded from the scope of those rules SLHCs with substantial insurance activities. See 12 C.F.R. §§ 3.2, 317.2 and 324.2. It is those SLHCs which would be covered by the ANPR.
  
² NAIC International Insurance Forum Speech, p.15.
  
³ See Sutherland's Legal Alert: President Signs Changes to Collins Amendment Favorable to Insurers 
  
⁴ NAIC International Insurance Forum Speech, p. 9.
  
⁵ See Daniel K. Tarullo, Governor, FRB, Remarks at the National Federal Reserve Bank of Chicago Bank Structure Conference: Rethinking the Aims of Prudential Regulation 15 (May 8, 2014), available at https://www.federalreserve.gov/newsevents/speech/tarullo20140508a.pdf, 
  
⁶ NAIC International Insurance Forum Speech, p. 6.
  
⁷ NAIC International Insurance Forum Speech, p. 10.
  
⁸ NAIC International Insurance Forum Speech, p. 13.  
  
⁹ Id.   

¹⁰ NAIC International Insurance Forum Speech, p. 6.

¹¹ At the time the FRB adopted the LCR, the FRB included the following statement with respect to SIIs:

The [FRB] intends to assess the business model, capital structure, and risk profile of the designated company to determine how the proposed enhanced prudential standards should apply, and if appropriate, would tailor application of the LCR by order or rule to that nonbank financial company or to a category of nonbank financial companies. The Board will ensure that nonbank financial companies receive notice and opportunity to comment prior to determination of the applicability of any LCR requirement.

Liquidity Coverage Ratio: Liquidity Risk Measurement Standards, 79 Fed. Reg. 61440, 61446 (Oct. 10, 2014).