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As Treasury snuffs out insurer systemic designations, states pick up the slack

As the Treasury Department signals what could be the end of labeling insurance companies as systemically risky 10 years after the financial crisis, the burden of overseeing the riskiness of large U.S. insurers is falling to the states.

Only Prudential Financial Inc. remains a designated nonbank systemically important financial institution, with American International Group Inc. and MetLife Inc. managing to escape the stricter oversight of that label, pending an appeals court decision that could complicate MetLife's status. Prudential may turn to the courts to end its own designation, as MetLife has done successfully.

But as regulators at Treasury and the Financial Stability Oversight Council loosen their grip on those companies, the National Association of Insurance Commissioners, or NAIC, has undertaken a series of initiatives to measure and shore up financial stability at the largest U.S. insurers.

"Though the insurance industry weathered the 2008 financial crisis, there were still lessons to be learned that resulted in updates to our solvency framework," said NAIC CEO Michael Consedine. Those updates have included a "holistic" review of solvency regulation, enhancements to the model holding company act, a requirement that companies undergo the Own Risk Solvency Assessment and a new cybersecurity model law.

The NAIC has also launched a macroprudential initiative, shepherded in its early stages by New Jersey Insurance Director Peter Hartt, who is the NAIC’s representative on the FSOC. It would subject life insurers to more surveillance and liquidity testing and could require them to create plans for how to be wound down in the event of a failure, similar to the so-called "living wills" that the largest banks have filed.

The desire to lose the federal SIFI designation did appear to encourage large insurers to simplify their businesses. AIG, a centerpiece of the financial crisis with its credit default swaps and securities lending activities, has downsized and reduced its risk profile. MetLife spun off its U.S. retail business into Brighthouse Financial Inc. Prudential has maintained that it never deserved the label to begin with.

But the removal of the label does not mean those insurers will return to pre-crisis behavior, said Thomas Leonardi, AIG’s executive vice president for government affairs, public policy and communications.

“I do not believe insurers will seek out riskier business simply because the federal government may have a reduced role,” he said, pointing to the stronger hand of state regulators. “Many companies have de-risked their balance sheets and are focusing on liquidity as well as capital.”

In one particular case of tougher state governance, New Jersey’s Department of Banking and Insurance took the extra step of hiring an industry veteran to be in charge of group-wide supervision for Prudential early in 2017.

The federal government’s newly relaxed stance was codified in a Treasury report released in November. The report called for an approach to recognizing systemic risk based on specific activities rather than on individual companies, a departure from the company-based SIFI label. Shortly after the report was published, Prudential said it was “encouraged” by the government’s support for an activities-based approach.

Some observers have cautioned that only paying attention to activities could still lead risky behavior to occur undetected. The risk profile of any given company is determined by the interconnectedness of its various activities, according to Daniel Schwarcz, a law professor at the University of Minnesota, who testified in October before a congressional committee.

Schwarcz pointed to the CDS and securities lending activities at AIG, which both posed the same risk to the company: that mortgage-backed securities would collapse and become illiquid. A solely activities-based approach to systemic risk regulation is not attuned to this type of interaction among activities at one firm, he argued.

The professor also noted that securities trading and lending still play a prominent role at some insurers, where they are deeply intertwined with life insurance operations.

"Insurers' massive role as investors means that they can pose systemic risks by triggering or exacerbating 'fire sales' of specific securities or types of securities," he said. "As AIG demonstrated, certain life insurer activities, like securities lending and derivatives trading, can create sudden liquidity needs."