Monday, December 28, 2015

No. 135: The Office of Financial Research in the U.S. Department of the Treasury Issues Its First Financial Stability Report

In 2010, in response to the Great Recession of 2007-2009, Congress enacted The Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act established the Office of Financial Research (OFR) as an independent bureau within the U.S. Department of the Treasury. Richard Berner is Director of the OFR. The OFR issued annual reports for 2012, 2013, and 2014, and will issue its annual report for 2015 in January 2016.

The Financial Stability Report
On December 15, 2015, the OFR issued its 142-page first Financial Stability Report, which the OFR describes as supplementing and preceding the annual report for 2015. The Financial Stability Report has an executive summary, a glossary, a bibliography, and five major sections: "Assessing and Monitoring Threats to Financial Stability," "Evaluating Financial Stability Policies," "Data Needs for Financial Stability Analysis," "Research on Financial Stability," and "Agenda Ahead."

Excerpts from the Financial Stability Report
The OFR's Financial Stability Report contains some important references to the insurance industry. Here are a few of those comments, with page numbers shown in brackets at the end of each comment:
[T]here are some indications of rising risks in the insurance sector, but progress on adopting heightened prudential standards for designated U.S. insurers remains slow. The relative lack of transparency about the process for identifying global systematically important insurers [G-SIIs] precludes public evaluation of how the risks they pose are changing over time. [Page 3]
In July 2013, the Financial Stability Board [an international coordinating body that monitors financial system developments on behalf of the G-20 nations] released an initial list of nine G-SIIs that were identified using the International Association of Insurance Supervisors (IAIS) assessment methodology. [Page 51]
The 2015 list of designated G-SIIs included three U.S. companies that FSOC [the Financial Stability Oversight Council, which was created by the Dodd-Frank Act and is chaired by the Secretary of the U.S. Department of the Treasury] has separately designated as companies whose material financial distress could pose a threat to U.S. financial stability and required additional oversight from the Federal Reserve: American International Group, Inc., MetLife Inc., and Prudential Financial Inc. The G-SII list also included six non-U.S. companies: Aegon N.V., Allianz SE, Aviva plc, AXA S.A., Ping An, and Prudential plc. [Page 51]
Broadly, the IAIS G-SII designation identifies insurance firms whose failure or distress could have adverse consequences in financial markets due to their size, market position, and global interconnectedness. At a later date, the IAIS is expected to update its assessment methodology to include reinsurance companies as well as revise its definition of nontraditional and noninsurance activities of G-SIIs. [Page 51]
[M]uch of the data for the IAIS's G-SII assessment methodology are not publicly available. The lack of disclosure of systemic importance data for G-SIIs and insurers just below the G-SII threshold precludes public evaluation of these firms' systemic footprint and how that may be changing over time. [Pages 51-52]
U.S. insurance companies currently are not subject to prudential standards on a consolidated basis to capture risks that they may be taking in noninsurance affiliates that are not subject to state-based supervision. [Page 52]
[T]he risks that some large life insurers pose to financial stability may be rising, according to certain market-based measures. [Page 53]
Financial statements filed with state regulators are the most reliable source of public information for U.S. insurance companies, but permitted deviations make it difficult to compare data across the industry. [Page 89]
Some regulators have expressed concern that too much flexibility by states in the treatment of insurance risks could encourage regulatory arbitrage by companies. [Page 89]
The lack of transparency in the activities of captive reinsurers within the U.S. life insurance industry is an area where more comprehensive access to additional data is needed. [Page 89]
Relatively little information is publicly available about captives' activities, capitalization, asset liability management, types of business reinsured, and the resulting reserve and capital benefits to the parent, or ceding, insurer. [Page 90]
There are also gaps in data available to analyze the risks insurance companies take in derivatives, variable annuities, and securities lending activities. [Page 91]
Related Recent Developments
On December 17, 2015, the FSOC approved a resolution reaffirming the G-SII designation of Prudential Financial Inc. The vote was eight to one; the independent member with insurance expertise opposed the resolution, and the Chair of the Securities and Exchange Commission recused herself.

MetLife Inc. has challenged its G-SII designation in court. The case is currently pending.

General Observations
Many observers of the Great Recession of 2007-2009 have said, based on hindsight, that the crisis took policy makers and the public by surprise. Therefore, one of the significant reforms undertaken in the wake of the crisis grew out of the perceived need for periodic reports not only for the benefit of policy makers but also for the benefit of members of the public about potential problems in our financial system. Dodd-Frank created the OFR for that purpose. The Financial Stability Report should be read not only by policy makers but also by members of the public.

Available Material
I am making available a complimentary 147-page PDF consisting of the OFR's 142-page Financial Stability Report and the FSOC's five-page resolution relating to Prudential Financial Inc. Send an e-mail to and ask for the December 2015 OFR/FSOC package.