“TO CONVERGE, OR NOT TO CONVERGE,” That is the Question for Regulators and Legislators: And the answer may prove vexing on this increasingly dramatic financial services stage.

Martin Carus Cover Story

Whether “’tis nobler in the mind to suffer the slings and arrows of outrageous fortune….” is besides the point for financial services decision-makers. The question here is whether there are “noble minds” pondering this question as respects current efforts to devise global capital standards for insurers. I’ll leave the answer to you the reader after we look at the question further.

First, though, consider whether there is convergence as regards:

Measuring weight, liquid, distance and temperature;
Languages, spelling, alphabets and language characters;
Culture, Art and Music;
Ethics (Huh, are you kidding!);
Governmental structure, legal codes;
Automobile driving conventions;
Electricity;
Money;
Religious beliefs.

In fact, noting the last item on my list, there isn’t even convergence as to what text makes up the “Old Testament.” Even that is not “converged.” And after thousands of years no less! Almost every one of the above items, if converged, would generate much greater cost efficiencies than anything to do with the assessment of capital adequacy of insurance groups. Efforts to do so have failed. Just walk a few meters through the challenges. Now, is it likely that the first globally accepted convergence should be relative to insurer group capital standards?

There seems to be this inexorable need on the part of financial system overseers to converge assessment systems of insurers which, in turn, would require a convergence of accounting standards used by insurers. If the latter is not achieved (and FASB and IASB have not been able to do so), how can the former be implemented? Some suggest allowing the use of different measurement standards and relying on outcomes. However, outcomes can only be gleaned after the fact and the purpose of assessment schemes is to direct the outcomes.

In any case, the effort regarding a global standard for financial assessment of insurers moves on and on. This need seems to have come about because the overseers have just realized that the financial services industry, and the insurance segment in particular, has become, or is, global in nature. That seems a startling discovery when noting that several large banks and insurers have been operating internationally for decades if not centuries.

A second factor emanates from the financial downturn during 2008-2009. They have concluded that certain institutions pose systemic risk. But, exactly what is “systemic risk”? In 2010, the Dodd-Frank Act (or its formal name, the WALL STREET REFORM AND CONSUMER PROTECTION ACT) was enacted “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” Reviewing the Act one will not find a clear definition of just what systemic risk means, particularly with reference to insurers. There is no sentence that starts: “Systemic risk means….” The closest one comes is in Section 113(a)(1) which states:

“(a) U.S. NONBANK FINANCIAL COMPANIES SUPERVISED BY THE BOARD OF GOVERNORS.— (1) DETERMINATION.—The Council…may determine that a U.S. nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards, in accordance with this title, if the Council determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States .” (Emphasis added)

Sounds good, but again exactly what does “a threat to the financial stability of the United States” actually mean? How does one tell? What level of threat? As a general proposition, Wikipedia defines systemic risk as “the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, which can be contained therein without harming the entire system. It can be defined as financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries. It refers to the risks imposed by inter-linkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading set of failures, which could potentially bankrupt or bring down the entire system or market.” (Italics mine) In other words, it’s calamity.

Certainly there is a level of what may be called “misery” that can be applied whenever something occurs that is discomforting. A couple planning a wedding puts a down-payment on a catering hall that then goes bankrupt. Result: misery. You place an order for furniture and make a down-payment. The furniture store goes bankrupt. Ergo: more misery. An insurer goes broke so one has to replace certain mandatory coverages. The result is inconvenience and misery. Perhaps it is a life insurer and now the insured is older and their health condition has declined, resulting in even more misery. Perhaps you have a claim or are a beneficiary under a policy and the amount due is more than the guaranty fund (i.e ., a policyholder protection plan) limits. Even greater misery! But, is any of this misery “a threat to the financial stability of the United States”? Does it suggest “the collapse of the entire financial system”? If five companies go down the tubes, indeed there is a great amount of misery but does misery equal financial system collapse?

So considering the hyped 2008-2009 market downturn and ensuing misery, exactly how many US policyholders, claimants and beneficiaries failed to receive payments made under insurance contracts? And that’s considering what is labelled as the worst downturn in 80 years. In short, there is not a high level of interconnectedness from one insurance group to another or from the insurance industry as a whole to other segments of the financial services sector.

What am I getting at here? Well, the efforts being expended to converge insurer financial assessment standards, and in particular the effort to devise a global capital standard for insurance groups, has been, is and will continue to be expensive. Meetings take place around the world and considering the impact on insurers’ operations and thus the insurance marketplace, they are attended by hosts of regulators, observers and other interested parties (e.g ., consumers). Yes, that’s right, consumers! Who bears the costs of all these efforts? Consumers do primarily inasmuch as costs directly incurred by insurers are reflected in product prices. Regulatory costs are generally either assessed to insurers which, in turn, include those costs in product prices or are borne by taxpayers. To the degree that marketplace competition doesn’t allow for the recoupment through product prices, then the costs are borne by shareholders through lower net incomes, lower returns on capital, lower dividends and lower share prices.

And even further, if such efforts bring the need for more capital, the cost of that capital will be borne by shareholders (through lower returns on capital or dilution) or by consumers through higher product prices inclusive of such costs. This leads to the question: What are the benefits of a group capital standard and assessment? There are a few things to consider which have not been adequately discussed in the public domain. These are:

Consumers buy products from individual insurers, not from insurer groups. They have no privity of contract with the parent or holding company affiliates of the particular insurer from which they made their purchases. The question then becomes why are insurance groups composed of individual insurance companies? There are some marketing reasons for there to be more than one insurer in a group (e.g ., different companies within a group specializing in different products). There are also some individual statutory reasons that engender that approach (e.g ., prohibitions against tiered underwriting). And, there are some capital provider reasons, the latter being the segmentation of capital so that a single overall problem doesn’t take down the entire franchise, the corporate veil so to speak. Thus, the fact that the group is adequately capitalized per a regulatory view does not necessarily translate into an increased probability that the individual promises insurance contracts represent will be met. This calls into question whether a view of a group’s capital position is relevant to any particular consumer of an individual group member’s product. There are no statutory rules relative to the fungibility of capital within a group (as there is in the banking sector by the way).
Thus, group-held capital doesn’t necessarily have to flow down to an individual insurer that might actually need that inflow at any given time. While regulators have and do cooperate, there is no global group statutory regulatory system in place that could guarantee that capital would flow in the indicated direction. And, there’s not likely to be such a system anytime soon. Suppose more than one downstream company needs the group capital; who would prioritize the flow of capital? Suppose further, that capital is down-streamed to individual insurers and then subsequently needs arise elsewhere in the group system; can the flow of capital automatically change direction? What if there are dividend limitations or the regulator of an individual insurer doesn’t believe it advisable to give up capital under its control to cure a problem elsewhere? Think about the answers to these questions in the political context. Would a domestic regulator (or any other jurisdictional regulator) decrease the probability of a company under its supervision meeting its responsibilities to that regulator’s constituents in order to increase the prospects for another policyholder of a different company within the group?
Consumers have policy protection schemes so that if their particular insurer from whom they purchased a product is unable to pay, the overall industry effectively provides a financial guaranty for that product. Yes, such schemes (or guaranty funds) have limits but then, who gets any of the possible benefit from the capital residing at the group level or perhaps within the holding company’s individual insurers? The answer is the people who bought high value coverages above the guaranty fund limits. If, for example, you have a $500,000 life policy in a jurisdiction with that level of policyholder protection scheme and the company goes broke, you (or more likely your beneficiary) get $500,000. If you bought a $50 million policy then there’s a different question. So, is this an effort to protect those who buy $50 million policies? Do only those consumers pay the freight for this effort?
Excepting mutual and reciprocal enterprises, most groups are headed by a holding company. Most of the larger of these are publicly traded entities. Insurers are subject to statebased particularized receivership and liquidation schemes supervised by state courts. However, holding companies are not subject to such a paradigm, they being subject to federal bankruptcy laws supervised by the Federal courts. Thus, how would the failure of a holding company interact with the failure of the holding company’s insurance company subsidiaries? What if the holding company fails but the insurers do not? What happens if the holding company fails and its non-insurer subsidiaries fail but the insurers do not? What happens in the reverse situations? What happens if the holding company and the insurer subsidiaries fail? Suppose the Federal courts decide one course of action that is contrary to the interests of the state courts?
Let’s suppose that the effort is successful and an agreed upon group capital system is obtained. To whom will it apply? Currently, it could apply to insurers deemed globally systemically important (G-SIIs) or domestically deemed systemically important groups (D-SIFIs), internationally active insurer groups (IAIGs), other insurer groups or all of the above. What is the competitive impact on the marketplace if not all groups are subject to such a standard, not only in consideration of the global marketplace but from the perspective of an individual jurisdictional or individual product category marketplace?
Since the idea is “to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes,” what would that group capital level be? If the determined level was accurate, presumably the level would be the present value of the probability of that undesirable bailout. But if that is indeed the case, then consumers (who, by the way, are also taxpayers and in many instances shareholders) are merely paying up front the cost of such a prevented bailout. Why? Isn’t that merely another tax? Moreover, what if the calculated standard is empirically correct but the groups to which it pertains all have capital significantly above that level (a prospect that seems eminently likely); then what is the benefit of this costly effort? Is the effort moot?

Again, what is the quantified benefit? We could determine the money spent; but can we get a quantifiable amount of benefit? Did anyone conduct a cost/benefit analysis before the effort was begun? Not to anyone’s knowledge. So, effectively consumers (and shareholders) have funded, and continue to be required to fund, the cost of this effort without any knowledge, or even an estimate, of any quantifiable benefit from the effort. That seems neither wise nor reasonable. In fact, as a consumer, to me it’s outrageous! Moreover, there doesn’t seem to be any benefit—for shareholders, taxpayers or even, startlingly, regulators!

As we say in some precincts of New York, “To be…or what?” Before the curtain rises on this play, we suggest a second, hard look at the script.

Martin F. Carus is President of Martin Carus Consulting, LLC and has spent 50 years in the insurance industry as one of New York’s acknowledged top regulatory thinkers and protagonists. From 1965 through 1999, he was a member of the New York Insurance Department (now the Department of Financial Services), rising to Chief Examiner. From 1999-2014, he was Senior State Relations Officer for the American International Group, Inc. where he acted as AIG’s Observer to the International Association of Insurance Supervisors.