REGULATORY REASONING: Supt. Lawsky Reflects on Approaches to His and Colleagues’ Roles

By Betty Flood and Katlin Nash

ALBANY, N.Y.—New York Superintendent of Financial Services Benjamin M. Lawsky spoke at the 22nd annual Hyman P. Minsky Conference on the state of the U.S. and world economies in New York State and what the Department of Financial Services is doing to improve the insurance and banking industries.

Superintendent Lawsky said, “In the wake of a devastating financial crisis law makers, regulators, the financial industry, consumer advocates, and a wide range of stakeholders are building a new architecture of a reformed Wall Street. That is a dynamic, ongoing process.” “Regulators need to remain vigilant because there is a constant danger that putting a thumb in the dike in one part of the financial system will cause a leak to spring somewhere else,” explained Lawsky.

The New York State Department of Financial Services (DFS) was created through a merger of two existing state agencies: the New York State Banking Department and the New York State Insurance Department and is only about eighteen months old.

“Sometimes financial regulators find that moving in a new direction is akin to turning a battleship in a bathtub. Institutional inertia can stymie even the most-well intentioned watch dogs,” said Lawsky. “When Governor Andrew M. Cuomo proposed creating DFS he gave us a clear mission. He wanted the industries DFS regulates to thrive. He wanted to keep New York the financial capital of the world,” explained Lawsky.

Forced placed insurance which is taken out by a bank on behalf of the home owner when a home owner does not maintain the insurance required by the terms of a mortgage was Lawsky’s first involvement in the new department. In October 2011 DFS launched an investigation into the forced placed insurance industry.

“When we conducted our investigation there was very little competition and very little high rates in the forced-insurance industry. Our investigation was looking at why this was happening when sometimes a homeowner who was already in financial trouble got ‘forced-placed’ into an insurance policy their rate jumped two to three times higher despite the fact that forced-placed insurance provides far less protection for home owners than voluntary insurance.”

DFS investigation produced a major settlement with the Country’s largest forced-placed insurer, Assurant which controls 70% of the market in New York. The settlement includes restitution for homeowners who were harmed, a $14 million penalty pay to the State of New York and industry-leading reforms that will save homeowners, tax payers, and investors millions of dollars going forward through lower rates.

“An additional settlement with the nation’s second highest forced-placed insurer QBE includes a $10 million penalty, restitution for homeowners, and New York’s industry-leading reforms. Companies representing more than 90% of this market in New York have signed onto our reforms,” explained Lawsky. “It was essentially a dirty little secret in the insurance industry.”

DFS has begun to play an important and instructive role in anti-money laundering. “We wanted the banking industry to take it a lot more seriously given the threat it posed not only to our financial system, but to our national security,” said Lawsky.

According to the Superintendent banks were sometimes effectively serving as financial terrorists, other enemies of our country and perpetrators of some of the most vile human rights abuses anywhere on earth. DFS took action against a particular bank, “Standard Charter Bank” in New York City. “Our investigation uncovered the bank had hidden from the US and other regulators roughly 60,000 secret transactions involving at least $250 billion, reaping the company hundreds of millions of dollars in fees. New York ended up securing a $340 million settlement and a set of reforms to stop these problems.” “The Independence and integrity of monitors and independent consultants is another area of vital concern to DFS,” said Lawsky.

“These consultants are installed at banks and other companies usually after an institution has committed serious regulatory violations or broken the law. The intent is the monitor assists companies in improving controls and ensuring violations do not reoccur.”

“However, the outcome of a mentorship is disappointing as we recently saw in the context of the national mortgage review. This can be blamed on a number of factors worth considering that our current system significantly undermines the independence of the monitors-the monitors are hired by the banks they’re embedded physically at the banks, they are paid by the banks, and the depend on the banks for future business,” claimed Lawsky.

Lawsky told the conference there is also insufficient communication between monitors and regulators. “Frequently monitors never hear from regulators once they are put in place at a bank. There needs to be regular meetings between regulators and monitors and weekly updates on progress should be happening. At DFS we have already instituted a more robust process in the selection of monitors and we will be pushing more broadly for change in the dynamics between regulators, monitors, and institutions. You will likely be seeing some innovative initiatives from DFS in this area in the coming weeks and months and we expect those actions will help propel reform at both the State and federal levels. One very important question we need to be asking is when monitors and consultants perform poorly or worse when they intentionally obscure problems at banks: what should the consequences be? Because if we allow intentional conduct aimed to quietly sweeping problems at banks under the rug, we are truly undermining our whole system of prudential regulation. At some point we must take action that has real consequences or the problem in our system will continue to be perpetuated rather than deterred.”

Superintendent Lawsky also hit on annuity companies that sell insurance products that essentially promise a certain payment every year or months whatever the terms of the policy may be over a particular period of time.

“If you look at the deals completed or announced to date, private equity-controlled insurers now account for nearly 30% of the indexed annuity market up from 5% a year ago and 15% of the total fixed annuity market up from 4% a year ago. This is driving DFS to take a close look at these transactions and these firms and to ensure the safety and soundness of these companies and consumers both remain protected.”

“Annuities are very popular products that a significant number of Americans rely on to help finance their retirements. The risk we are concerned about at DFS is whether these private equity firms are more short termed focused when this is a business that is all about the long haul.”

“Because of their potential short term focus there is a risk that these companies may not be delivering the level of compliance and customer service that we’d expect of them given the importance of this product to so many seniors on fixed incomes. If just a few of these investments work out than the firm can be very successful and the failed ventures are just viewed as a cost of doing business.”

“Private equity firms typically manage their investments with a much shorter time horizon for example three to five years than is typically required for prudent insurance company management. They may not be long term players in the insurance industry and their short-term focus may result in an incentive to increase investment risk and leverage in order to boost short-term returns. At DFS we regulate banks and insurance companies. Private equity firms rarely acquired control of banks, not because there are prohibited from doing so, but because the regulatory requirements associated with such acquisitions are more stringent than a private equity firm may like. These regulatory requirements in the banking industry are designed in part to encourage a long-term outlook and ensure that person controlling the company has real skin in the game. The long term, nature of the life insurance business raises similar issues, yet under current regulations it is less burdensome for a private equity firm to acquire an insurer than a bank. Private equity firms typically manage their investments with a much shorter time horizon for example three to five years than is typically required for prudent insurance company management. They may not be long term players in the insurance industry and their short-term focus may result in an incentive to increase investment risk and leverage in order to boost short-term returns. We need to ask ourselves whether we need to modernize our regulations to deal with this emerging trend to protect retirees and to protect the financial system and it is one where DFS is moving to ramp up its activity.

Another area DFS is looking at relates to the use of captive insurance companies used to off-load risk and increase leverage at some for the world’s largest financial firms.

Superintendent Lawsky said, “Insurance companies use these captives to shift blocks of insurance policy claims to special entities often in states outside where the companies are based or else offshore such as the Cayman Islands in order to take advantage of looser reserve and oversight requirements. In July 2012, the DFS initiated a serious investigation into this somewhat obscure area, which could put insurance policy holders and taxpayers at greater risks. In a typical transaction an insurance company creates a “captive insurance subsidiary” which is essentially a shell company owned by the insurer’s parent. The company then “reinsures” a block of existing policy claims through the shell company and diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve requirements for the captive shell company are typically lower.”

Lawsky said, “This financial alchemy, let’s call it ‘shadow insurance,’ does not actually transfer the risk for those insurance policies off the parent company’s books, because in many instances the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted (‘a parental guarantee’). This means that when the time finally comes for the policy holder to collect their promise benefits after years of paying premiums such as when there is a death in their family there is a smaller reserve buffer available at the insurance company to ensure that the policy holders receive the benefits to which they are legally entitled.”

“We are hard at work and are continuing investigation into shadow insurance and we hope to shed light on and further stimulate a national debate on this important issue to our financial system,” concluded Lawsky.