The Murky World of Off-Balance-Sheet Items (Part 2)

See part 1 here.

There has been much debate over whether or not the repeal of the Glass-Steagall Act contributed to the current financial crisis. This Act was originally put in place to separate commercial and investment banks because of reckless actions taken by commercial banks in the 1920s. As a result of these reckless actions, when the stock market bubble burst in 1929, commercial banks’ exposure to Wall Street, together with a lack of deposit insurance and other backstops, brought the banking industry to its knees. And thus it’s easy to see how the repeal of this Act in 1999 is linked to the current financial crisis.

Whatever your opinion may be regarding this, I’m sure we can all agree that greed, accounting loopholes and a lack of financial and regulatory oversight have played major roles in the banking sector’s woes today. And I can only imagine the current situation getting worse as more Off-Balance-Sheet Items (OBSIs), and their resulting obligations that were previously hidden, are consolidated into companies’ financial statements. But the reason I make mention of the repeal of the Glass-Steagall Act, which brought about fundamental changes in the banking sector, is that there are now plans in place to repeal collateral requirements in the insurance industry.

The National Association of Insurance Commissioners (NAIC) is currently considering a proposal (pdf warning) that would treat certain insurance companies, currently non-authorized or accredited to do business in various states, the same as authorized or accredited insurance companies when it comes to collateral requirements, effectively making these obligations OBSIs. What makes this even more interesting however, is that even before these changes have been approved by the NAIC, the State of Florida has already implemented these changes, and the states of New York and Texas are already in the process of developing their own rules. So much for working together on something as important as this!

To facilitate a better understanding of the impact of the proposed changes, let’s look at existing situation. Current collateral requirements mandate that any U.S. or non-U.S. reinsurance company not authorized or accredited to operate in a state must post collateral equal to 100 percent or greater of its share of policyholder claims and reserves. This is the case even if the non-state authorized or accredited company has a top credit rating and is financially strong. Whilst these requirements ensure that recovery for obligations will more then likely be matched by collateral posted, it’s plain to see that these requirements reduce the amount of reinsurance a non-state authorized or accredited reinsurer can offer, and imposes the cost of posting the collateral. The irony is that companies authorized or accredited in a state have no such requirement even if they are financially weaker then the ‘foreign’ reinsurer.

So what impact will the proposed changes have? Per the NAIC document, it will now allow “for a state with the appropriate regulatory capacity to be a sole U.S. regulator of a reinsurer writing assumed business in the United States.” The document goes on to mention that a framework will be put in place which will allow states with resources, expertise and experience to regulate its reinsurers’ reinsurance business. More importantly the document discloses that “a consultative process will be created to facilitate the resolution of disputes among insurance regulators regarding reinsurance issues. This consultative process shall be localized within the supervisory board of the RSRD (Reinsurance Supervision Review Department) which will consist of state insurance regulators. After consultation, the decision by the home state….supervisor with respect to the financial solvency of the reinsurer will be final.”

At a minimum, this sounds like good job security for those in the insurance industry. But in bringing Part 2 to a close, am I the only one worried about the impact of these changes? After all, we’ve seen how ‘effective’ regulation has been in the banking sector since the repeal of the Glass-Steagall Act. And we’ve also seen how quickly companies like AIG, an authorized and ‘financially’ secure insurance company, can implode because of collateral obligations that were OBSIs. Surely it’s time for more centralized oversight, not less? I guess only time will tell.

Comments

[cubanstockp...:]

UNH has $15 billion worth of those and hasn't commented on it since 2007. Hmmm.

2008 Dec 09 12:08 PM

[BerkeleyBob:]

I have long thought that reinsurance was largely unregulated. It is not clear that AIG was acting as an insurance carrier, and the linguistic obfuscation surrounding its transactions is strikingly similar to that of the Enron traders. Historically, the federal oversight of the insurance industry was largely ceded to the states. The collapse of Executive Life was a devastating blow to the recipients of structured tort settlements who were entirely dependent on annuity income. I think the NAIC is off base on their proposal. The relationship of the insurance industry to an increasingly international financial market needs further exploration--state regulation can't adequately address an AIG, which I elsewhere described as an off shore bookie, not an insurance carrier.

2008 Dec 09 02:56 PM