The Impact of the Financial Regulatory Reform Legislation on the Life Insurance Industry - Financial Services

The financial regulatory reform legislation entitled the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (the "Dodd-Frank Act" or the "Act") was signed into law on July 21, 2010 by President Obama. This DechertOnPoint examines the provisions in the Dodd-Frank Act that affect the life insurance industry, with a focus on the provisions relating to:

Federal government oversight of significant nonbanks for financial stability;
Federal orderly liquidation authority;
Creation of a new Federal Insurance Office ("FIO");
Harmonization of the standard of conduct for broker-dealers and investment advisers;
Potential effects of the "Volcker Rule";
Regulation of over-the-counter derivatives; and
State regulation of indexed annuities (the "Harkin Amendment").

While explicit references to insurance companies form a small part of this comprehensive legislation, relative to the focus on the banking industry and "Wall Street," Congress has highlighted "enhanc[ing] Federal understanding of insurance issues" as one of the key goals of the legislation. ¹ The potential impact of the Dodd-Frank Act on insurance companies and their affiliates is significant and may expand over time as regulators move forward on the plethora of studies and rules called for by the Act.

Introduction and Observations

The Dodd-Frank Act is intended to put in place a framework to address perceived weaknesses in the regulatory structure of the U.S. financial system that contributed to the financial crisis of 2008. As the most comprehensive legislation addressing financial institutions in many years, the Act impacts life insurance companies and their affiliates in ways that can be significant. Many of its provisions call for studies or rules, so the complete impact from the Act is not now known, and the regulatory developments set in motion by the Act, as well as potential "unintended consequences," will need continued attention. Here are some observations on the Act's potential effects on life insurance company complexes:

Federal vs. State Regulation of Insurance. The role of the States in the regulation of insurance companies has been the subject of extensive policy and political debate for many years.² In the context of the Dodd- Frank Act, neither Congressional leaders nor Obama administration officials chose to take on the fight of proposing Federal regulation of insurance. Thus, the Act leaves the current regime of State regulation largely intact, and, in one respect, strengthened by the Harkin Amendment's rebuff of the assertion of jurisdiction over indexed products by the Securities and Exchange Commission ("SEC"), as discussed herein. The Act does, however, pave the way for possible future Federal regulation of insurance by creating the new Federal Insurance Office, which is charged with the task of studying potential Federal regulation of insurance.
Potential Federal Prudential Supervision over Insurance Organizations as "Significant Nonbanks." There is one important exception to this principle of the continuing primacy of State regulation: the Act gives potential regulatory authority to Federal banking and other regulators and the newly-formed Financial Stability Oversight Council ("Council") over large insurance complexes. The Act seeks to protect against possible threats to U.S. financial stability by extending strict prudential Federal supervision to certain financial companies that are not bank holding companies. The Act authorizes the newly-formed Council to determine that material distress at a nonbank financial company or the nature or operations of the company could pose a threat to financial stability, and to determine that the company should be supervised by the Board of Governors of the Federal Reserve System ("FRB") (such a designated company is referred to herein as a "Significant Nonbank"). The Council could designate an insurance organization (a parent holding company for an insurance complex or one or more insurance companies) as a Significant Nonbank. A company that is designated as a Significant Nonbank must register and file reports with the FRB and is subject to heightened prudential standards including capital and liquidity requirements.
Potential Federal Initiation of the Liquidation of an Insurance Organization. Under Title II of the Act, the Secretary ("Treasury Secretary") of the Department of the Treasury ("Treasury") may under certain conditions initiate the liquidation of a Significant Nonbank or another company predominantly engaged in financial activities – which, in either case, could be an insurance company or a parent holding company of an insurance company complex. A liquidation of a Significant Nonbank that is not an insurance company generally would be conducted under a Federal receivership structure administered by the Federal Deposit Insurance Corporation ("FDIC"). In the case of an insurance company, upon a determination by the Treasury Secretary, liquidation or rehabilitation would be conducted under applicable State law, and initiated by a State insurance commissioner, or, if the insurance commissioner fails to act after 60 days, by the FDIC.
The "Volcker Rule." This provision prevents proprietary trading as a principal, subject to certain exceptions, and restricts sponsorship and investment in hedge funds and private equity funds by "banking entities," a term broadly defined to include, among others, nonbank companies with an affiliated insured bank or savings association (an insured depository institution). If an insurance complex owns an insured depository institution, these prohibitions will apply to the entire complex, subject to certain exclusions for non-U.S. entities. An exception will allow insurance companies to conduct proprietary trading for their general accounts, and will allow banking entities to conduct proprietary trading for customers, among others. However, for an insurance complex that owns an insured depository institution, this measure could change proprietary trading practices and could seriously inhibit hedge fund and private equity fund formation and operation for any entity within the complex. Thus, insurance complexes that own an insured depository institution will want to study and assess their options from the potential impact of the Volcker Rule, which will not be fully developed until the relevant regulatory agencies conduct related studies and adopt implementing rules. In addition, even without being affiliated with an insured depository institution, a U.S. insurer designated as a Significant Nonbank could be subject to additional capital requirements and restrictions related to its proprietary trading and hedge and private equity fund activities.
Potential Fiduciary Duty for Broker-Dealers. The Dodd-Frank Act calls for the SEC to study and consider rules to impose a fiduciary duty standard on broker-dealers for the purpose of harmonizing the standards of care owed by broker-dealers and investment advisers for personalized investment advice to retail customers. The subject of harmonization proved controversial during the legislative process, and many insurance industry advocates, among others, opposed adoption of a fiduciary duty standard for broker-dealers. The final version of the legislation, which requires a study but leaves rulemaking discretion in the SEC's hands, reflects a compromise. It includes language clarifying that receipt of compensation for the sale of securities shall not be considered a violation of any rules the SEC may adopt, and that broker-dealers that sell only proprietary products may do so with notice and consent. Yet, the SEC and the Financial Industry Regulatory Authority, Inc. ("FINRA") historically have been critics of certain sales practices for variable products,³ and the SEC ultimately approved a FINRA rule establishing customized sales practices and suitability standards for variable annuities. ⁴ The SEC study and potential rulemaking bear watching for potential implications for the sale of variable products.
Regulation of Over-the-Counter Derivatives. Title VII of the Dodd-Frank Act creates a comprehensive regulatory framework for the over-the counter ("OTC") derivatives market. Many key provisions require further rulemaking by the SEC and the Commodity Futures Trading Commission ("CFTC"). Of interest to insurers will be whether they come within the definitions of categories of persons with significant activities in OTC swaps and other derivatives. One of these categories is a "major swap participant", which would require registration with the SEC or CFTC, and would subject the insurer to new capital and margin requirements and various reporting obligations. Also of interest is whether derivatives transactions of insurers must be submitted for centralized clearance, or whether they would be eligible for an exception from clearance for certain persons who use OTC derivatives to hedge or mitigate commercial risk. Another item left unanswered in the final version of the legislation is whether stable value contracts will be considered "swaps" that would be subject to the substantive regulation of the OTC derivatives market. The Act calls for this determination to be made by the SEC and CFTC in a joint study to be published 15 months after enactment of the Act.

Federal Government Oversight for Financial Stability

At the heart of the Dodd-Frank Act are provisions that represent a response to the expenditure of Federal dollars in 2008 and 2009 to support ailing financial institutions. Title I of the Dodd-Frank Act deals with financial stability and creates a new Financial Stability Oversight Council and gives the Council considerable power to promote stability in financial institutions. These powers could be exercised over life insurance companies and other types of insurance companies and their affiliates.

The Financial Stability Oversight Council

The Dodd-Frank Act creates the Council, which is charged with identifying and responding to emerging risks throughout the financial system. The purposes of the Council are: (i) to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, inter-connected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace; (ii) to promote market discipline, by eliminating expectations on the part of the shareholders, creditors and counterparties of such companies that the Federal government will shield them from losses in the event of failure; and (iii) to respond to emerging threats to the stability of the United States financial system. ⁵

In addition to other duties, the Council is charged with monitoring domestic and international financial regulatory proposals, including insurance and accounting issues. The Council is to advise Congress and make recommendations in areas that will enhance the integrity, efficiency, competitiveness, and stability of the financial markets. Interestingly, the Act specifically called out insurance issues as one of the areas for which the Council is to monitor and provide advice.

The Council will consist of 15 members – ten voting and five nonvoting – consisting of the heads of many of the agencies that oversee financial matters and financial institutions^{. 6} Significantly, the director of the FIO and a State insurance commissioner are nonvoting members.

Supervision by the FRB

Under the Act, the Council, by a vote of no fewer than 2/3 of its members then serving, including an affirmative vote of the chairperson, has the authority to designate any "U.S. nonbank financial company" as a Significant Nonbank that will be supervised by the FRB and be subject to enhanced supervision and regulatory standards developed by the FRB ("prudential standards"). To reach this determination, the Council must determine that the company's material financial distress, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities, could pose a threat to the financial stability of the United States. Upon an affirmative vote to treat a company as a Significant Nonbank, the "financial activities" of the organization are subject to prudential supervision.⁷ The FIO, discussed below, will have the authority to recommend to the Council that it designate an insurer as a Significant Nonbank.

The definition of "U.S. nonbank financial company" in the Dodd-Frank Act includes companies that are incorporated or organized under the laws of the United States or any State. Accordingly, any insurance company that is "predominantly engaged" in financial activities and incorporated or organized under the laws of any State could be eligible for designation as a Significant Nonbank. ⁸

Considerations

In making a determination that a company, including an insurance company, is a Significant Nonbank, and thus will be subject to FRB supervision, the Council is required to consider:

The extent of leverage of the company; #
The amount and nature of the company's financial assets;
The amount and type of liabilities of the company, including the degree of reliance on short-term funding;
The extent and type of off–balance sheet exposure of the company;
The extent and type of the company's interrelationships with other significant financial companies;
The importance of the company as a source of credit for households, businesses, and State and local governments, and as a source of liquidity for the U.S. financial system;
The importance of the company as a source of credit for low-income, minority or underserved communities, and the impact that the failure of the company would have on the availability of credit in those communities;
The extent to which the company's assets are managed rather than owned and the breadth of the dispersion of the ownership of assets under management;
The nature, scope, size, scale, concentration, interconnectedness and mix of the company's activities;
The degree to which the company is already regulated by one or more primary financial regulatory agencies; and
Any other factors the Council deems appropriate.

The Council is required to consult with the primary financial regulatory agency, if any, for each nonbank financial company or subsidiary of a nonbank financial company that is being considered for designation as a Significant Nonbank before the Council makes a determination. The "primary financial regulatory agency" for insurance companies is the "State insurance authority of the State in which an insurance company is domiciled."⁹

Nonbank financial companies determined by the Council to be Significant Nonbanks must register with the FRB within 180 days after the date of a final Council determination, and will be subject to reporting requirements prescribed by the FRB.

Procedural Requirements

The Council must provide written notice to the nonbank financial company of a proposed determination of Significant Nonbank status, including an explanation of the basis for the proposed determination. The nonbank financial company may request an opportunity for a written or oral hearing before the Council to contest the proposed determination.

A nonbank financial company determined to be a Significant Nonbank has 30 days after the receipt of the notice of final determination to bring an action for an order requiring that the final determination be rescinded. However, judicial review is limited to whether the final determination was arbitrary and capricious.

Prudential Standards

The FRB is responsible for establishing prudential standards and reporting and disclosure requirements applicable to Significant Nonbanks, subject to input from the Council. Historically the FRB has imposed supervision on banks through supervision of bank holding companies, and this pattern may be repeated for large insurance complexes. Accordingly, an insurance company or its parent holding company could be a Significant Nonbank. In either event, the FRB is required to supervise the Significant Nonbank and may establish prudential standards for:

Risk-based capital requirements and leverage limits, unless the FRB, in consultation with the Council, determines that such requirements are not appropriate for a company subject to more stringent prudential standards because of the activities of such company (such as investment company activities or assets under management) or structure, in which case, the FRB shall apply other standards that result in similarly stringent risk controls;
Liquidity requirements;
Overall risk management requirements;
Resolution plan and credit-exposure reporting requirements; and
Concentration limits, including the prohibition from having credit exposure¹⁰ to any affiliated company that exceeds 25% of its capital stock and surplus (or such lower amount as the FRB may determine by regulation to be necessary to mitigate risks to the financial stability of the United States).

The FRB may establish additional prudential standards for Significant Nonbanks, including:

A contingent capital requirement that the Significant Nonbank maintain a minimum amount of contingent capital that is convertible to equity in times of financial stress;
Enhanced public disclosures to support market evaluation of the Significant Nonbank's risk profile, capital adequacy and risk management capabilities;
Short-term debt limits,¹¹ including the off-balance sheet exposures that may be accumulated by the Significant Nonbank; and
Such other prudential standards as the FRB shall deem appropriate. 12 The FRB is required to submit an annual report to Congress regarding the implementation of the prudential standards required, including the use of such standards to mitigate risks to the financial stability of the United States.

Resolution Plan and Credit Exposure

Each Significant Nonbank will be required to have a plan for rapid and orderly resolution in the event of material financial distress or failure, which shall include:

Information regarding the manner and extent to which any insured depository institution affiliated with the company is adequately protected from risks arising from the activities of any nonbank subsidiaries of the company;
Full descriptions of the ownership structure, assets, liabilities, and contractual obligations of the company; and
Identification of the cross-guarantees tied to different securities, identification of major counterparties, and a process for determining to whom the collateral of the company is pledged.

Each Significant Nonbank is required to report periodically to the FRB, the Council and the FDIC on: (i) the nature and extent to which the company has credit exposure to other significant nonbank financial companies and significant bank holding companies; and (ii) the nature and extent to which other Significant Nonbanks or large bank holding companies have credit exposure to that company. ¹³

Risk Committee

Each Significant Nonbank that is publicly traded is required to establish a risk committee within one year of the final determination of Significant Nonbank status. The risk committee must: (i) be responsible for the oversight of the enterprise-wide risk management practices of the Significant Nonbank, presumably with a focus on financial risk management; (ii) include such number of independent directors as the FRB may determine appropriate, based on the nature of the operations, size of assets, and other appropriate criteria related to the Significant Nonbank; and (iii) include at least one risk management expert having experience in identifying, assessing and managing risk exposures of large, complex firms.

Stress Testing

The FRB, in coordination with the appropriate primary financial regulatory agency and the FDIC, is required to conduct annual analyses in which Significant Nonbanks are subject to evaluation of whether such companies have the capital, on a total consolidated basis, necessary to absorb losses as a result of adverse economic conditions. The FRB: (i) is required to provide for at least three different sets of conditions under which the evaluation shall be conducted, including baseline, adverse and severely adverse; (ii) may require stress tests in addition to the annual test requirement; (iii) may develop and apply such other analytic techniques as are necessary to identify, measure and monitor risks to the financial stability of the United States; (iv) may require companies to update their resolution plans as the FRB determines necessary based on an analysis of the results; and (v) shall publish a summary of the test results.

In addition, a Significant Nonbank must conduct semiannual stress tests. The company must submit a report to the FRB and its primary financial regulatory agency at such time, in such form, and containing such information as the primary financial regulatory agency shall require.

Early Remediation

The FRB, in consultation with the Council and the FDIC, is authorized to prescribe regulations to establish early remediation requirements for Significant Nonbanks that are experiencing financial distress, which could include limits on capital distributions, acquisitions, and asset growth, and capital-raising requirements, among others.¹⁴

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Footnotes

^{1.See Joint Explanatory Report of the
Committee of Conference.}

^{2 See Puretz, Jeffrey, Background
Information: A Primer on Insurance Products as Securities,
published in Practising Law Institute, Securities Products of
Insurance Companies in the Face of Regulatory Reform (2010),
Section I.D., "Efforts to Increase Federal Regulation,"
describing studies, Treasury Department papers, and congressional
bills to increase Federal regulation of
insurance.}

^{3 See Joint SEC/NASD Report on Examination
Findings regarding Broker-Dealer Sales of Variable Insurance
Products, June 2004. See also BNA Securities Regulation and Law
Report, Volume 25 Number 25, June 21, 2004, "Variable
Annuities – Glassman Warns Insurance Companies
– Brokers: SEC Focusing on Variable Annuities." See
also Statement by SEC Commissioner Annette Nazareth, Remarks Before
NASD Spring Securities Conference, May 18, 2006, stating that
"[v]ariable annuities have been a source of longstanding
concern at the Commission, NASD, and other regulators...Therefore,
I believe that variable annuity sales raise heightened investor
protection concerns and that appropriate suitability determinations
would go a long way to allaying these concerns. " See
generally Wilkerson, Carl, The Convergence of Regulatory
and Industry Initiatives Governing Suitability, Supervision,
Disclosure, and Credentialing in the Sale of Annuities,
published in Practising Law Institute, Understanding the Securities
Products of Insurance Companies (2009); and Wilkerson, Carl,
FINRA Rule 2821: Suitability and Supervision in the Sale of
Variable Annuity Contracts, published in Practising Law
Institute, Securities Products of Insurance Companies in the Face
of Regulatory Reform (2010).}

^{4 FINRA Conduct Rule 2821.}

^{5 Section 112 of the Dodd-Frank
Act.}

^{6 The ten voting members are: (i) the Treasury
Secretary, who serves as chairman; (ii) Chairman of the FRB; (iii)
Comptroller of the Currency; (iv) Director of the Bureau of
Consumer Financial Protection, which is created by the Act; (v)
Chairman of the SEC; (vi) Chairperson of the FDIC; (vii)
Chairperson of the CFTC; (viii) Director of the Federal Housing
Finance Agency; (ix) Chairman of the National Credit Union
Administration Board; and (x) an independent member with insurance
expertise, appointed by the President, by and with the consent of
the Senate. The five nonvoting members are: (i) the Director of the
Office of Financial Research; (ii) the director of the FIO,
discussed below; (iii) a State insurance commissioner; (iv) a State
banking supervisor; and (v) a State securities commissioner. The
State insurance commissioner to serve on the Council will be
selected pursuant to a selection process determined by the State
insurance commissioners and can only serve for a term of two years.
The non-voting members may not be excluded from any proceedings,
meetings, discussions or deliberations of the Council, except by
the chairperson of the Council, upon the vote of the member
agencies, when necessary to safeguard and promote the free exchange
of confidential supervisory information.}

^{7 The term "financial activities" is
defined to include: (i) activities that are financial in nature as
defined in Section 4(k) of the Bank Holding Company Act ("BHC
Act"); and (ii) the ownership or control of one or more
insured depository institutions. The term "financial
activities" does not include internal financial activities
conducted for the company or its affiliates, including internal
treasury, investment and employee benefit functions. Nonfinancial
activities of a company shall not be subject to supervision or
imposition of prudential standards of the FRB. Note that under
Section 113(c)(3) of the Act, a nonbank financial company may
establish or may be required by the FRB to establish an
intermediate holding company that would hold all entities engaging
in financial activities.}

^{8 A company is "predominantly engaged" in
financial activities if: (i) the annual gross revenues derived by
the company and all of its subsidiaries from activities that are
financial in nature and from insured depository institutions
represent 85% or more of the consolidated annual gross revenues of
the company; or (ii) the consolidated assets of the company and all
of its subsidiaries related to activities that are financial in
nature and related to the ownership or control of insured
depository institutions represent 85% or more of the consolidated
assets of the company.}

^{9 Section 2(12)(D) of the Dodd-Frank
Act.}

^{10 For this purpose, "credit exposure" to
a company means: (i) all extensions of credit to the company,
including loans, deposits, and lines of credit; (ii) all repurchase
agreements and reverse repurchase agreements with the company, and
all securities borrowing and lending transactions with the company,
to the extent that such transactions create credit exposure for the
nonbank financial company; (iii) all guarantees, acceptances or
letters of credit (including endorsement or standby letters of
credit) issued on behalf of the company; (iv) all purchases of or
investment in securities issued by the company; (v) counterparty
credit exposure to the company in connection with derivative
transactions; and (vi) any other similar transactions that the FRB,
by regulation, determines to be a credit
exposure.}

^{11 "Short-term debt" is defined to
include such liabilities with short-dated maturity that the FRB
identifies, by regulation, except that such term does not include
insured deposits.}

^{12 These prudential standards are set forth in
Section 165 of the Dodd-Frank Act.}

^{13 If a credible plan is not submitted in a timely
manner, the FRB and the FDIC may jointly impose more stringent
capital, leverage, or liquidity requirements or restrictions on the
growth, activities or operations of the company or any subsidiary,
until a credible plan is submitted. The FRB and the FDIC, in
consultation with the Council, may direct a Significant Nonbank to
divest certain assets or operations identified by the FRB and the
FDIC to facilitate an orderly resolution of such company under the
Bankruptcy Code. The reference to the Bankruptcy Code in Title I
does not provide an exemption for insurance companies, which
generally are subject to State liquidation or conservation
authority. In contrast, allowance is made for State insolvency
proceedings for insurance companies in Title II, described in
"Orderly Liquidation Authority,"
below.}

^{14 Dodd-Frank Act, Section 166.}