Insurance and Systemic Risk: A Detailed Analysis

The Misguided Case of Insurance SIFI Designations Scott E. Harrington Alan B. Miller Professor Wharton School, University of Pennsylvania Bowles Symposium on Systemic Risk Department of Risk Management and Insurance Georgia State University Atlanta, Georgia November 3, 2016 1

Overview Insurance and systemic risk Banks vs. insurers Insurers and the financial crisis Post crisis research FSOC designation of insurance SIFIs under Section 113 of the Dodd-Frank Act Process FSOC rationales and dissents MetLife challenge, court decision, appeal Activities-based assessment as an alternative 2

Designation Timeline Court rescinds MET designation, 3/30/16 MET final AIG, GE final designations, 7/8/13 designation, 12/18/14 PRU final designation, 9/4/13 MET files suit , 1/13/15 FSOC rescinds GE designation, 6/28/16 PRU designation hearing, 7/23/13 MET designation hearing, 11/3/14 MET court hearing, 2/10/16 FSB designates AIG, MET, PRU as G-SIIs, 7/18/13 AIG, PRU, GE proposed designations, 6/3/13 FSOC appeals, 4/8/16 MET proposed designation, 9/4/14 3

Assets, Liabilities, and Book Equity of Largest U.S. Banks and Insurers (March 31, 2016, $millions) JPMORGAN CHASE & CO $2,423,808 BANK OF AMERICA CORP $2,185,498 WELLS FARGO & CO $1,849,182 METLIFE INC $917,428 GOLDMAN SACHS GROUP INC $878,036 MORGAN STANLEY $807,497 PRUDENTIAL FINANCIAL INC $772,995 AMERICAN INTERNATIONAL GROUP $502,777 U S BANCORP $428,638 BANK OF NEW YORK MELLON CORP $372,870 PNC FINANCIAL SVCS GROUP INC $360,985 LINCOLN NATIONAL CORP $255,718 STATE STREET CORP $243,685 HARTFORD FINANCIAL SERVICES $227,493 VOYA FINANCIAL INC $214,008 BB&T CORP $212,405 SUNTRUST BANKS INC $194,158 FIFTH THIRD BANCORP $142,430 AMERIPRISE FINANCIAL INC $140,250 CITIZENS FINANCIAL GROUP INC $140,077 REGIONS FINANCIAL CORP $125,539 M & T BANK CORP $124,626 NORTHERN TRUST CORP $117,799 GENWORTH FINANCIAL INC $107,173 ALLSTATE CORP $105,947 TRAVELERS COS INC $101,680 $0 $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 Long-Term Debt - Total Other Liabilities Book Equity 4

Systemic risk Threat to overall financial system with spillovers on real activity Large, macroeconomic shocks Interconnectedness among institutions and associated contagion Possible sources of contagion: Counterparty risk some firms may be unable to honor their commitments, causing some counterparties to likewise default, etc. Liquidity concerns spur fire sales and depress asset prices and holdings of institutions with similar assets Uncertainty/opacity of financial problems at some institutions creates general uncertainty, making parties reluctant to trade until further information is available Runs by depositors, policyholders, investors 5

Is life insurance systemically risky? Consensus without unanimity: core activities pose little or no systemic risk Financial distress does not threaten the payment system or short-term lending Fundamentally different from banking Much less potential for widespread harm to economic activity Medium to long-term assets, relatively illiquid medium to long term liabilities associated with death protection and long-term savings Asset liability matching, extensive hedging Substantial liquidity Many contracts pass most or all investment risk to contract holders Strong market incentives for adequate capitalization and risk management 6

NAIC Risk-Based Capital Ratios (Adjusted Capital to Company Action Level RBC) for Aggregate Life Industry and Leading MetLife and Prudential Entities 2006-2015 700% 600% 500% 400% 300% 200% 100% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Metropolitan Life Insurance Co. MetLife Insurance Co. USA Prudential Insurance Co. of America Aggregate Life Industry 7

Early 1990s insolvencies Large reductions in high yield debt and commercial real estate values Some sizable life insurers failed Executive Life, First Capital Mutual Benefit Life Withdrawals of funds were localized No evidence of contagion Subsequent changes in regulation NAIC solvency regulation accreditation Development of risk-based capital requirements 8

2007-2009: AIG was singular and pathological AIG s crisis was not caused by core insurance activities Its CDS problems were unique Its securities lending problems were unique We don t fully understand how an AIG failure would have affected its non-insurance counterparties, which were recipients of the bulk of the federal assistance AIG was subject to consolidated supervision (by the Office of Thrift Supervision) Large banks experienced severe problems despite extensive regulation by the Fed, including problems related to off balance sheet vehicles 9

Beyond AIG Mortgage/financial guaranty insurers were badly damaged The rest performed remarkably well Large losses in 2008, substantial rebound in 2009 Operating cash flow increased in 2008 Premiums, apart from AIG, were relatively stable Surrenders and withdrawals decreased 2008-2010 Parent organizations contributed substantial capital to some insurance subsidiaries Substantial new capital raised in private markets in 2008-2009 Some insurers received minimal support from federal liquidity and assistance programs (details in paper) Some modification of regulatory capital requirements to reduce strain on reported capital Post crisis: NAIC Solvency Modernization Initiative 10

U.S. Life Industry Net Income and Change in Surplus ($000) $60,000,000 $40,000,000 $20,000,000 $0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 -$20,000,000 -$40,000,000 -$60,000,000 Net Income Industry Net Income without AIG Change in Surplus Industry Change in Surplus without AIG 11

U.S. Life Industry Direct Life and Annuity Premiums ($000) $250,000,000 $200,000,000 $150,000,000 $100,000,000 $50,000,000 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Life Premiums Industry Life Premiums without AIG Individual Annuity Individual Annuity without AIG Group Annuity Group Annuity without AIG 12

U.S. Life Industry Operating Cash Flows, Surrenders & Withdrawals, and Changes in Deposit Balances ($000) $300,000,000 $200,000,000 $100,000,000 $0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 -$100,000,000 -$200,000,000 -$300,000,000 -$400,000,000 Cash from Operations Industry Cash from Operations without AIG Surrenders & Withdrawals Industry Surrenders & Withdrawals without AIG Change in Deposit Balances Industry Change in Deposit Balances without AIG 13

Post-crisis research on micro behavior Reduced prices in 2008 to improve reported profits and capital? Financially constrained insurers: More likely to sell downgraded, speculative grade bonds and RMBS, with downward pressure on asset prices Reached for yield before the crisis Runs for certain funding agreement backed notes Captive reinsurance issues Internal validity? How important (external validity)? 14

Quantitative research on systemic risk Based in part on correlation in stock returns in down markets (MES, highly correlated with equity beta) Some measures rank a few life co. highly (e.g., SRISK) Seemingly precise, but not accurate Different risk measures yield significantly different rankings Little attention/linkage to underlying drivers of potential contagion Assumptions not tailored to specific sectors (SRISK: common prudent capital ratio; book liabilities; no consideration of nature or duration of liabilities; no distinction of separate account liabilities; assumption that market losses require raising capital) SRISK very highly correlated with total liabilities 15

FSOC designation of nonbank SIFIs Section 113 of the Dodd-Frank Act Designation, subject to enhanced regulation by the Federal Reserve, . . . 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. Three stage, quantitative and qualitative evaluation First Determination Standard: material distress poses threat to stability Second Determination Standard: activities pose systemic risk 16

FSOC designations, cont. Intertwined with FSB designations of G-SIIs Based exclusively on First Determination Standard Basic rationale is the same for each insurer Material financial distress could lead to runs by contract holders and counterparties That in turn could lead to fire sales of assets and attendant contagion Woodall dissent (Prudential) The underlying analysis utilizes scenarios that are antithetical to a fundamental and seasoned understanding of the business of insurance, the insurance regulatory environment, and the state insurance company resolution and guaranty fund systems. As presented, therefore, the analysis makes it impossible for me to concur because the grounds for the Final Determination are simply not reasonable or defensible, and provide no basis for me to concur. 17

The D.C. District Courts MetLife decision Judge Rosemary Collyer rescinded MetLife s designation on two grounds: (1) failure to consider MetLife s vulnerability to financial distress, as implied by its guidance, and (2) failure to consider any costs of designation to MetLife, which was arbitrary and capricious. [E]very possible effect of MetLife s imminent insolvency was summarily deemed grave enough to damage the economy. FSOC s appeal: The Court read into the guidance an obligation to assess the likelihood that MetLife would experience distress and a requirement to identify with precision the impact that distress would have on the broader financial system during a hypothetical future crisis. The Court also erred in holding that the FSOC was required to consider the cost of designation to MetLife. 18

Legal issues aside The expected benefits of enhanced regulatory supervision need to be considered in relation to the expected costs, even if those benefits and costs cannot be readily quantified. The expected benefits depend on the probability of distress. If it is argued that the consequences of financial distress at a specific institution are so high that there is no need to consider the probability, it is incumbent to establish a compelling case that the consequences could be extremely serious. Appropriate economic regulation requires consideration of potential costs. Accurate quantification is not necessary or feasible. Any argument that potential systemic harm is so great that any costs must be regarded as negligible should be based on correspondingly strong evidence and analysis. 19

Potential consequences of life insurer SIFI designation For life insurers, consumers, and markets 1. At least in the short run, significant risk of excessive regulatory burdens and costs for companies designated as systemically important, disrupting competition and harming customers 2. Possible risk migration 3. In the long run, risk of increased moral hazard, less market discipline, and expansion of too big to fail For regulation / supervision 1. Fixed costs and lags in developing appropriate expertise and rules for very few entities 2. Potential diseconomies of scope in Federal Reserve supervision of banks and nonbank SIFIs 20

The activities-based assessment alternative Focus on activities rather than individual companies The FSB has moved towards an activities-based approach for asset management, and perhaps the FSOC European insurance regulators and IAIS are discussing, and the FSOC could be doing so as well. Target attention on underlying risk with systemic potential Address all entities participating in a particular activity Consider the potential accumulation of risk across entities If an activities-based approach had been in effect, it s possible that the financial crisis would have been substantially mitigated or even prevented 21

Economically efficient regulation At its best, economic regulation involves enforcement and compliance costs, is inherently imperfect, and risks significant, unintended consequences Regulation should only be employed when: Substantial evidence of significant market failure Substantial reason to believe that the benefits will exceed the costs Regulatory tools should be carefully matched with specific market failures I don t regard insurance SIFI designation under Section 113 as consistent with this framework 22