-- This article was written by Ronald Orol of The Deal
Federal Reserve Governor Daniel Tarullo on Friday described a tough capital regime that the central bank will introduce in the coming weeks for big systemically important insurers American International Group (AIG) and Prudential (PRU) but he assured them that compliance costs will be "considerably lower" than what big banks must endure.
"By constructing a separate consolidated approach to capital for systemically designated insurance firms, compliance costs for these firms should be considerably lower than if they had to conform to the bank holding company capital regime," Tarullo said in a speech to a group of state regulators, the National Association of Insurance Commissioners.
Both Prudential and AIG's share prices were up in early trading on the news, a positive response to Tarullo's speech and his pledge that they will face "considerably lower" compliance costs. AIG's shares spiked upwards to $56.83, or 0.82% while Prudential's share price moved upwards to $78.65, or 2%.
Jaret Seiberg, analyst at Guggenheim Partners, notes that the proposal the Fed will introduce will be a so-called "advance notice of proposed rulemaking," which suggests to him that a final rule may not be completed until late 2017, which means he doesn't believe that Prudential or AIG will come under a difficult stress testing regime until 2020 or 2021. He notes this also represents "positive news" for big SIFI insurers.
Nevertheless, the regime will be tougher than one Tarullo said the Federal Reserve is expected to set up for other insurers the central bank oversees because they own a bank. However, he added that the added measures are "justified" by the increased risks to the financial system that big insurers pose.
Both Prudential Financial and American International Group were designated by a council of regulators as Systemically Important Financial Institutions, of SIFIs. Both big insurers are subject to SIFI rules because the group of regulators, the Financial Stability Oversight Council, believes that the global insurers are a potential threat to economic stability.
Big insurers have been waiting over five years for some details about their new regulatory regime since the Dodd-Frank Act, written in the wake of the 2008 financial crisis, set up the SIFI system.
Tarullo, in his speech, said those rules, at least a proposal for them, will be introduced in the coming weeks.
He sought to differentiate between big banks and large insurers, noting that the funding structure for large insurance companies is more stable than that of commercial banks and broker dealers. However, he alluded to the operations set up by AIG and Prudential by noting that the balance sheet of an insurance company can look quite different than that of a traditional bank.
"The extensive involvement of an insurance firm in securities lending, repo, over-the-counter derivatives, and other capital markets activities can create a balance sheet with much tighter connections to the rest of the financial system and greater liquidity risk in times of financial market stress," Tarullo said. "The positions of the insurance company are large enough, it could become a potential vehicle for transmitting distress at the company to other parts of the financial system."
In addition, Tarullo said that the two big insurers will be subject to tough liquidity rules and they will likely be required to conduct capital and liquidity stress tests to determine if they have enough capital to withstand an economic crisis.
In addition, they will be required to set up contingency plans to manage stress and they will need to conduct internal stress tests. Prudential and AIG are both already required to write annual so-called living wills explaining how they would dismantle themselves in a crisis.
Nevertheless, one large insurer, MetLife (MET), likely won't need to deal with these new requirements. The insurer's stock price was up 1.65% to $45.04, likely in response to investor relief that it had found a way - for now - around the new restrictions.
MetLife took a two-pronged approach to avoiding them. First, it sued the federal government over the prospective rules and in April a federal court judge ordered regulators to remove the company's SIFI designation. In addition, MetLife moved to divest and spin off a large part of its U.S. retail business as part of an effort pare down its size and complexity to make sure it isn't designated again.
Isaac Boltansky, analyst at Compass Point Research & Trading in Washington, said last month he believes the Federal Reserve will propose SIFI insurance capital and liquidity rules in the first half of 2016 and that the package of measures will likely increase the regulatory burden on AIG.
Tom Sullivan, chief of the Fed's insurance policy section, in September said the agency is investing significant time and resources, including new staff members, to set up a capital framework for the big insurers.
In 2014, Congress approved a measure that gave the Federal Reserve the authority to set up liquidity and capital rules specifically for SIFI insurers, rather than subjecting them to tougher bank-like capital regulations. The move was viewed at the time as a relief to Prudential and AIG because the measure clarified that they would not need to be subject to the same rules as big banks, which are also designated as SIFIs.
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