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November 30, 2012

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Basel III a Bad Fit: Insurance CFOs

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Banking executives and lobbyists are not the only ones voicing displeasure over Basel III, the new global regulatory framework for bank capital. At a joint hearing of the House Financial Services Committee on Thursday, finance chiefs from State Farm and TIAA-CREF said the proposals from U.S. regulators were burdensome and “ill-fitted” for insurers’ savings and loan businesses.

State Farm, TIAA-CREF, and some other insurers operate savings and loan holding companies (SLHCs), banking units established in the past decade or so designed to provide customers a broader financial-product set. But the insurers’ forays into banking may prove costly if U.S. banking regulators don’t decide to treat these businesses differently under the Basel III framework.

The Basel III rules impose on financial institutionshigher standards for capital, leverage, and liquidity, designed to protect against another banking crisis. But insurers have “starkly” different business models, risk exposures, and capital needs than do banks and traditional bank holding companies, said Paul Smith, CFO of State Farm Mutual Automobile Insurance, at the hearing.

“The regulatory mismatch creates tremendous and costly difficulties in the recordkeeping, accounting, and reporting requirements for a number of SLHCs,” said Smith in his prepared statement, “while offering little, if any, commensurate benefit to regulators in understanding the capital needs and financial state of the companies impacted.”

Insurance companies have their own risk-based capital framework, set with a formula from the National Association of Insurance Commissioners, that Virginia Wilson, CFO of TIAA-CREF, said “accounts for the type of risk inherent in insurance.”

“Unlike banks, insurers’ stable liabilities [i.e., uncertain future payments to clients] provide them far greater freedom to choose when to sell assets, and they are unlikely to be forced to liquidate assets to satisfy short-term obligations in times of economic difficulty or market disruption,” Wilson said in her statement to the committee.

Smith seemed most concerned with the requirement that all insurance-based SLHCs use generally accepted accounting principles (GAAP) in preparing financial statements as well as in reporting to the Federal Reserve Board, their new regulator. State Farm, like other insurers, currently uses statutory accounting principles (SAP), a state-mandated accounting system.

A recent study done on behalf of State Farm and its subsidiaries found it would take four years and up to $150 million initially “to implement a consolidated GAAP and regulatory reporting process,” Smith said.

There are “numerous differences between the two accounting systems,” said Wilson in her statement, “which is that SAP focuses on insurer solvency where GAAP focuses on an organization’s earnings.” She suggested the Fed go back to the drawing board with respect to insurance-based SLHCs and develop a new proposed rule for public comment.

Given the spectacular failure and unprecedented government bailout of American International Group during the financial crisis, however, insurers may have trouble convincing regulators to shift their posture. Marc Jarsulic, chief economist at Better Markets, said in his prepared statement that the AIG example demonstrates that SLHCs “can easily pose threats to overall financial stability.”

But Kevin McCary, commissioner of the Florida Office of Insurance Regulation, said Basel III would not have prevented the AIG meltdown. “Regulatory requirements need to be applied to unregulated financial risks, [like] limiting the ability to write derivatives for a certain threshold of covered positions,” he said in his statement. “Frequent solvency monitoring, off-site and on, must be performed; and risks of unregulated entities within the group must be a part of this monitoring.”

It was the buildup of trillions of dollars in credit-default swaps in the Financial Products unit of AIG — a business with little or no regulatory oversight — that led to the company’s liquidity crisis in 2008.

Federal banking agencies have not released the final Basel III rules for the United States, but the Basel Banking Committee has recommended a phase-in period of 2013 to 2018. U.S. banking regulators said in early November that the process was not far enough along for any of the proposed Basel III rules to take effect this January 1.

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