Expressing concern about risky business in the insurance sector, an advisory committee at Treasury is recommending that its financial data analysis office undertake a detailed study of the sector to look at systemic risk issues and how these risks are handled by the current regulatory framework, the state system.

The proposal sounded muted alarm that regulatory arbitrage could be driving the organization of some parts of the industry and that leverage and illiquidity, as measured broadly, could be rising. (A copy of the proposal is embedded below.)

It also specifically called out the property/casualty insurance industry’s cycle of hard and soft markets as a potential source of systemic risk that could fuel widespread failures of insurers and reinsurers.

OFR provides services to the FSOC, its members and staff. Its recent study on asset management and financial stability garnered criticism from investment management companies for some of its assumptions, which companies decried as misleading and inaccurate (see for example, http://www.sec.gov/comments/am-1/am1-23.pdf). FSOC is now looking at asset managers as potential systemically important financial institutions (SIFIs), along with a couple of insurance companies, including MetLife and possibly Berkshire Hathaway.

An OFR official said that the proposal by a subcommittee of the OFR’s Financial Research Advisory Committee (FRAC) is just that—a recommendation to the OFR, not an action item of any immediacy.

The OFR will “contemplate” the recommendations made at Tuesday’s meeting and then “contemplate them further” before any action is undertaken, this person stressed, although the recommendation was not a surprise to the OFR.

OFR has looked at banking, at asset management, at the sell side, but perhaps it is time to take a closer look at insurance now, the advisory subcommittee felt.

Members raised issues with credit insurance as a big item to review if an insurance study is undertaken.

The OFR source said that the OFR will likely be staffing up on insurance sector hires to gain some heft in the insurance field. Of the nearly 200 OFR staff, none are said to be primarily insurance sector-raised personnel.

“This is not prejudging the idea that there are necessarily systemic risks in the insurance sector, but there are several reasons why we think it is at least worth asking the question,” said Anil Kashyap, advisory committee member and a professor of economics and finance at the University of Chicago. Kashyap, who is also an advisor to the Swedish Riksbank and a consultant to the Federal Reserve Bank of Chicago, spoke during the meeting Tuesday.

Indeed, the recommendation does state that the study should clarify areas of the industry that are “less likely to pose threats to financial stability.”

The OFR is being very thoughtful and looking at its skill sets and seeing where it needs help. In property/casualty, for example, there is a need to build up that expertise, the OFR representative said.

The study proposal acknowledges that two large insurers (Prudential Financial and AIG) have already been designated by the FSOC as SIFIs but finds a hole in work done so far under Dodd-Frank in that “a comprehensive review of industry practices and organizations to assess risks to financial stability has not been undertaken,” the study proposal stated.

Banks are indeed different from insurers, according to the proposal, but perhaps in a good way, it suggests. Although the assumption is that insurance is highly regulated, the proposal concerned itself with the point that the insurance industry is subject to fragmented regulation that is unfocused on systemic risk and, aside from the two insurance SIFIs, really has no liquidity backstop, as the banks do with the FDIC and the Federal Reserve.

The study proposal from the data-driven OFR advisory committee pointed in particular to the inadequacies of data collection by a central regulator on insurance company holdings and risk exposures, calling insurance firms “opaque” and the industry “complicated.”

Another troubling area, according to the proposal, is the P/C industry’s cyclical profits as markets go from hard to soft and back to hard again. While many are used to this, the proposal underscored a concern that this means there are period during which underpricing of risk becomes an industrywide phenomenon, possibly precipitating “coordinated failures among multiple insurance and reinsurance companies.”

The insurance proposal is “where we both want to build expertise as well as do some additional work. We hadn’t conceptualized it exactly as this kind of study on systemic risk, but it certainly fits in within OFR’s mandate as well as some of the work we have done with other council members,” said Patricia Mosser, OFR deputy director for research and analysis, after listening to the insurance study recommendation during the open advisory committee meeting.

Despite OFR seemingly welcoming a new insurance wing, any such insurance study by OFR faces a tough flight path to lift off. OFR itself is not planning on accepting this recommendation, according to a person familiar with the issues. There is enough happening on the insurance front between FSOC and FIO that there is not a need for further study by the OFR at this time, this person said, echoing a sentiment expressed elsewhere.

The FRAC met in an open session in Washington Tuesday and reviewed several recommendations. The third, the insurance sector proposal, comes from FRAC’s research subcommittee and was propelled by the work of FRAC member Trevor Harris, a Columbia Business School accounting and corporate finance professor, with input from fellow FRAC member insurance industry veteran Prakash Shimpi, borrowed from FRAC’s risk subcommittee. Harris did not return a phone call before publication.

The proposal references the work of academics on systemic risk and the insurance industry, including: Mary Weiss and David Cummins of the Temple University Department of Risk, Insurance and Health Care Management; Scott Harrington, Professor of Health Care Management and Professor of Insurance and Risk Management at Wharton; Robert Hartwig of the Insurance Information Institute; the International Association of Insurance Supervisors (IAIS).

Insurance sector participants were wary of the proposal, its stated concerns and any future study itself, while some welcomed the news that OFR would be taking on new hires in the area of insurance.

“Knowledgable insurance experts and regulators have all determined that property and casualty insurance does not present systemic risk,” said Dave Snyder, vice president of international policy for the Property Casualty Insurers Association of America (PCI). “Further, it proved that during the real-world test of the financial crisis. It would seem that OFR’s resources would be better spent on other financial services,” he said.

A person involved with the FSOC who asked not to be identified expressed “surprise” at the recommendation.

“The OFR work is directed by the FSOC. The FSOC did not ask for such a study, and the FSOC is keeping the OFR plenty busy these days,” this person said. The OFR is an office within Treasury, but the office with the insurance expertise is the [Federal Insurance Office] FIO. It seems odd that such a study would not be tasked to the FIO,” this person said.

FIO, along with the National Association of Insurance Commissioners (NAIC), as well as actuaries, brokers, underwriters, national and international accounting boards, and academics are among those the OFR would engage in completing any study, under the recommendation. That’s because of the differences between insurance and the rest of the financial industry with which the OFR is familiar, the advisory subcommittee’s recommendation suggests.

The NAIC said it looks forward to providing insurance regulatory expertise and guidance to the Office of Financial Research as it considers a request to study systemic risk in the insurance sector.

Separately, the FSOC’s nonvoting insurance member and Missouri Director of Insurance John M. Huff said, “As far as I know, neither OFR nor Treasury has reached out to state insurance regulators.”

In drafting the Dodd-Frank Act, which created the OFR and FIO, some stakeholders pushed for OFR to coordinate with FIO for insurance information gathering, but this did not make it into the completed 2010 legislation.

Other FRAC recommendations dealt with accounting and research and analysis.

http://www.scribd.com/doc/209658423/FRAC-Research-OFR-Study-on-the-Insurance-Sector-Recommendation