State Farm Mutual Automobile Insurance Issues Public Comment on Treasury Department Notice

WASHINGTON, Jan. 22 -- Keesha-Lu Mitra, vice president for counsel at the State Farm Mutual Automobile Insurance Co., Bloomington, Illinois, has issued a public comment on the Department of the Treasury notice entitled "Federal Insurance Office Study on the Insurance Capital Standard". The comment was written on Jan. 14, 2021, and posted on Jan. 21, 2021:

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Introduction

State Farm Mutual Automobile Insurance Company ("State Farm Mutual") respectfully offers these comments regarding the proposed International Association of Insurance Supervisors ("IAIS") Insurance Capital Standard ("ICS"). State Farm Mutual is a United States mutual insurance company established in 1922 and is the parent of the State Farm group of companies. Headquartered in Bloomington, Illinois, State Farm Mutual itself is the largest insurer of automobiles and, through its subsidiaries, the largest insurer of homes in the United States. State Farm Mutual and its subsidiaries comprise eleven property and casualty ("P&C") insurance companies, three life insurance companies, and a small number of noninsurance entities, including State Farm Bank./1

State Farm Mutual is regulated by the State of Illinois Department of Insurance as its domiciliary regulator for financial strength and governance, and currently is also prudentially supervised by the Federal Reserve Board as a savings and loan holding company. State Farm Mutual is not an internationally active insurance group ("IAIG").

State Farm Mutual appreciates the opportunity to submit these comments and related answers to the October 9, 2020 Notice ("Notice") seeking comments regarding a future study by the Federal Insurance Office ("FIO") to evaluate the potential effects of the ICS regulatory scheme. This group supervision-related study seeks to understand the effects of ICS if it were to be placed on U.S. insurance markets, U.S. consumers, and U.S. insurers. The study would also evaluate ICS's effect on the current state-based solvency regime that is tailored to the entire state-based regulatory structure. State Farm Mutual understands that FIO intends to use responses to inform its work on ICS, and that Version 2.0 of ICS was adopted by the IAIS in November 2019, with a five year monitoring period starting in 2020.

State Farm Mutual understands that the IAIS has been developing a global ICS since 2013 with the intent to develop a common language among regulators for addressing the capital adequacy of insurance groups that have cross-border operations with the goal that this ICS would deliver comparable outcomes across jurisdictions. State Farm Mutual further understands that the ICS is based on a total balance sheet approach that specifically recognizes the interdependence of assets, liabilities, regulatory capital requirements, and capital resources in order to ensure that all relevant financial risks of an IAIG are appropriately recognized./2

State Farm Mutual appreciates the prudential aspirational goal of gaining international regulatory efficiency for insurance groups that have cross-border operations or IAIGs; however, we continue to assert that the underlying philosophy of capital interdependence is fundamentally flawed, and wholly inconsistent with U.S. legal and regulatory requirements and practices. State Farm Mutual has previously provided similar comments./3

More specifically, the group capital standard as pursued by the IAIS is built upon the bank-centric premise that all capital should be fungible and owned universally within a group of insurance companies. Simply put, this isn't how the U.S. system works.

The premise that capital owned by individual entities within a group is freely available for the risks and use of all affiliates in the group is not applicable under the U.S. state-based regulatory structure. As a result of the unique risks presented and regulatory structure, the U.S. state-based overall regulatory scheme is focused on the insurer writing the contract and conditionally promising to pay. Under this regulatory structure, insurers' contracts are regulated by the state for content, price/rate, and overall trade practices such as claim handling and underwriting. In addition to the U.S. regulatory scheme for insurers' issuance and handling of a contract, the U.S. regulatory solvency scheme was developed based on the individual insurer meeting its financial obligations and made uniform in order to allow U.S. state regulators to rely on their counterparts under the National Associations of Insurance Commissioners' ("NAIC") Accreditation Program.

Under this regulatory construct, absent extraordinary circumstances,/4 U.S. insurers' capital is owned by that insurer primarily for use for its policyholders and is not fungible; and therefore there is no such thing as available "group" capital. State Farm Mutual is not saying that capital held by entities in a group could not be normalized and aggregated to represent an amount of aggregated capital for evaluation of risk related to the entities and their solvency. However, treating that calculated amount as if required and identifying capital held above that aggregated amount as available for use in the normal course, not only is inapposite with the U.S. insurance regulatory scheme, but also it potentially violates established non-insurance U.S. corporate law. Finally, it should be noted that an extra measure of policyholder protection exists in the U.S. regulatory structure, as each state has established a guaranty fund system to assist insurance policyholders in the event of benefit payment defaults by insolvent insurers.

As a result of the U.S. based regulatory structure being entity-centric, the following is a summary of State Farm Mutual's primary concerns about the assumption and implications of capital fungibility from U.S. legal entity and insurance regulatory perspectives:

1. The state-based U.S. system of legal entity insurance regulation has been tremendously beneficial to consumers. Although no system is perfect, the competitiveness and resiliency of domestic U.S. insurance markets is time-tested and proven. Any efforts to force a new international regulatory system upon the U.S. should be approached with caution and a healthy degree of skepticism given the unintended potential adverse consequences upon U.S. insurance markets and insurer capacity to best serve U.S. consumers.

2. U.S. insurance company capital is not fungible. Because capital of the individual insurer is intended to support its contractual promises, it is not freely movable between legal entities as if owned on a group level of an insurance holding company. While a calculated combined measurement or aggregation of capital for an insurance holding company may be beneficial to a U.S. regulator for the purposes of evaluating risk potentially posed to an individual entity due to the additional transparency provided, it is not meaningful to gauge the financial strength of the separate U.S. insurance entities in that group; that analysis is already done through insurance regulations such as Risk-Based Capital. And, any attempt to treat insurance company capital as fungible has the potential to pit one group of insurance consumers against another.

3. Regulating U.S. insurers of an insurance holding company group as if capital is held by the group and available for member entities to meet their obligations ignores the fundamental principles of contract law and imposes contractual obligations upon insurance entities and their policyholders that are not party to the contract.

4. Any concept of capital fungibility and availability would disrupt U.S. state-based insurance regulation on several points. State Farm Mutual and other insurance affiliates work as needed with state insurance regulators to offer contracts covering particular risk in a state, adopt rates that are adequate, not excessive or unfairly discriminatory based on the risk insured under the contracts and the maintenance of the issuing insurer's solvency as measured by U.S. state regulation.

5. Unless individually adopted by all states, application of ICS to U.S. insurers would be contrary to and inconsistent with Congressional direction (expressed in McCarran-Ferguson and reiterated by Dodd-Frank) to preserve state power to regulate the business of insurance. And because impacts would not be limited to solvency, it would be difficult for regulators and insurers alike to understand and apply jurisdiction.

6. Rather than setting a "standard" that seeks to reorder insurer solvency regulation and is highly disruptive to settled law and practices, the IAIS should focus its efforts, as originally contemplated by the Financial Stability Board ("FSB"), on tools that assist regulators in identifying potential threats to worldwide financial stability.

State Farm Mutual's answers to FIO's questions in the Notice follow. Thank you for your consideration.

Keesha-Lu Mitra

Vice President - Counsel

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State Farm Mutual's Response to Notice Questions:

Answer to Question 1. Because of the assumption of capital fungibility, broad U.S. adoption of the ICS would introduce a variety of legal and practical concerns for insurance regulators, insurers, and consumers:

- Federal adoption and broad application of group capital requirements/standards, including intervention points, would cause regulatory confusion vis-a-vis state and federal regulators regarding roles and responsibilities for many aspects of insurer solvency.

* As further explained below, such confusion may not be limited to solvency but instead may extend to contract regulation such as ratemaking, a core aspect of state insurance regulation and the business of insurance.

- Treatment of capital as fungible across U.S. insurance entities would upset established law and regulatory treatment and thus would lead to prolonged litigation and continued uncertainty.

* These impacts would extend well beyond the insurance and financial services sector: failure to recognize legal entity boundaries in this sector naturally will lead to renewed attempts to circumvent entity boundaries in civil litigation as well as regulatory activity in other sectors.

- Perceived availability of other entities' capital could simultaneously:

* Inflate insurance rates as entities consider risks that their capital - maintained to pay claims of their policyholders - may be diverted to meet needs of other entities' policyholders.

* Encourage state insurance regulators to suppress actuarially-justified rates on the grounds that capital needs may be supplemented by capital of other entities. In addition, many states would be incentivized to direct out-of-state insurers to subsidize rates paid by in-state policyholders.

- Such capital uncertainty would, as a matter of prudential necessity, increase upward pressure on insurance premiums beyond levels than would otherwise be needed.

* In some cases, insurers may decide to forego offering valuable insurance products to consumers in certain jurisdictions due to the inability to limit financial risk to the assets of specific companies. And, this extra-territorial capital reach is unnecessary due to longstanding use of state guaranty funds and similar state-based arrangements to help address insurance claims that otherwise would remain unpaid due to the insurer's financial impairment.

* Rating consequences of capital fungibility as pursued by the IAIS conflict with congressional intent and express language concerning the FIO's authority under 31 USC Sec. 313(j)(1)(A), which precludes the FIO from disrupting state measures governing insurance rates and premiums.

Answer to Question 2. State Farm Mutual does not engage in regulatory arbitrage activity and would not want to speculate on how other entities might try to exploit the ICS and other regulatory regimes. However, it appears that the ICS and its presumption of capital fungibility actually doubles down on some of the same risk factors that contributed to the financial crisis of 2008. That is, during prosperous times, corporate leaders sought to leverage high performing assets in one part of the group to support activities elsewhere in the group. Consequently, when those assets experienced stress, the contagion was more pronounced throughout the entire group. In other words, the ICS actually enhances opportunities for regulatory arbitrage.

Answer to Question 3. The FIO study should begin with an assessment of the AM as an assessment tool because that is the only system consistent with governing U.S. Law. FIO should study how the ICS compares to the current U.S. solvency regime with the addition of the AM evaluation tool. FIO should then focus on the significant legal and regulatory challenges that would be introduced by the ICS approach of treating capital as fungible across legal entities. By contrast, the AM can be used to provide more insight to the entity-level solvency for those entities that are not insurer-led while considering the current solvency structure of individual insurance entities.

Any approach that conflicts with the applicable state-based system would create misalignment with the way insurers are run and regulated, therefore making the ratings irrelevant at best and misinforming to the users who depend on them at worst.

Answer to Question 4. As noted in response to Question 1, the following should be considered:

- Insurers may face significant upward pricing pressures to account for the risk that entity capital may be diverted to meet obligations of other entities; and

- Insurers may choose not to offer certain products in certain U.S. jurisdictions due to the potential that entity financial risks may not be limited to the capital of that entity, but instead may extend to related entities.

Answer to Question 5. State Farm Mutual is not significantly internationally active and is not an IAIG. While we support efforts to enhance the competitiveness of U.S. insurers choosing to conduct business overseas, we do not believe these efforts should supersede U.S. state-based insurance law or undermine well-functioning domestic insurance markets meeting the needs of U.S. consumers.

Answer to Question 6.a. State Farm Mutual does not suggest any additional data sources to be evaluated and would respectfully reference 31 U.S.C. Sec. 313(e)(4), which mandates use of existing, available (including from state insurance regulators) information before seeking more in accordance with the Paperwork Reduction Act, 44 U.S.C. Sec. 3501 et seq.

Answer to Question 6.c.i. The FIO should recognize that risks indeed vary; accordingly, a uniform framework may not prove ideal. While the types of financial risk and stresses generally may be consistent across non-U.S. banks, insurance-related risks and stresses vary greatly across U.S. jurisdictions. Examples of such risks include those presented by wildfire, hurricane, and earthquake. U.S. state insurance regulators have significant experience understanding and resolving rating and capital needs, and the FIO Study should recognize state-based differences as a feature rather than an inconsistency warranting harmonization.

Answer to Question 6.d.ii. As noted above, the concept of capital fungibility presents significant legal and regulatory challenges as applied to U.S. insurers.

Answer to Question 8. The FIO Study should be designed to demonstrate and offer a vigorous defense of the state-based U.S. system of insurance solvency regulation. The FIO Study, as well as the application of the ICS, should focus on IAIGs and insurance holding companies with cross-border operations. We remain concerned that in endeavoring to achieve greater regulatory comity focused primarily on systemic risk and solvency at a group level, the ICS disregards our federal system of government and congressional determinations concerning the regulation of the business of insurance and the well-being of U.S. consumers.

Answer to Question 9. COVID-19 reinforced the concern that the ICS fails to recognize the current U.S based regulatory structure that regulates insurers' solvency on an entity basis and contracts on a state based platform. The handling of COVID-19 varied by states as to liability, risk exposure, and rating.

Answer to Question 11. It is important to note some of the history surrounding the ICS and also to make a distinction between internationally active life insurance companies and the P&C industry.

The driving force behind the IAIS's development of an ICS was the FSB's request to the IAIS, in the immediate aftermath of the 2008 financial crisis, to develop an appropriate standard that could be applied to IAIGs deemed systemically important. We expressed strong concern at that time that, similar to evolution of the Basel standards for banking which were originally intended for only the largest internationally active banks with worldwide systemic implications, regulators would ultimately seek to impose such standards upon all regulated entities. Time has proven that fear to be well-justified, although we'd suggest it's still not too late to make the appropriate course correction.

In addition, we would like to remind FIO that traditional P&C insurance operations did not pose a threat to U.S. financial stability and do not warrant the type of disruption to our business model generated by an ICS. Recall, that except for American International Group ("AIG"), P&C insurance groups had nothing to do with financial crisis, nor did they experience material financial distress. AIG's non-insurance operations created systemic risk, not because there was no capital standard for the group, but rather because it found a way to leverage the financial strength of its insurance companies to engage in riskier activities. Moreover, AIG's life operations in securities lending and other life insurance companies suffered significant losses during the financial crisis, necessitating pursuit of taxpayer assistance./5

We also note that the principal proponents of the ICS in the United States are the largest internationally active life insurance companies. State Farm Mutual understands their desire not to be disadvantaged in foreign jurisdictions and does not want to disrupt efforts to achieve international competitiveness. However, uniformly applying the ICS to a diverse range of insurers serving different types of consumers, with radically different product offerings, exposures, and regulatory requirements is deeply troubling. Most notably, disregard for the fundamental concept that domestic P&C insurers are subject to rate regulation in numerous lines of insurance - a factor entirely absent in the European Union, which has been the main driver behind the ICS - is deeply troubling. Consequently, to the extent an ICS is being discussed, we would suggest that it would be far preferable to advocate for and allow such life companies to voluntarily adhere to an IAIS standard rather than disrupting the entire US P&C industry and domestic life insurance industry as well.

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Footnotes:

1/ State Farm Bank in in the process of liquidation, after which State Farm Mutual will deregister with the Federal Reserve Bank of Chicago. This work is expected to be completed by April 2021.

2/ IAIS, Risk-Based Global Insurance Capital Standard Version 2.0 Public Consultation, July 31, 2018, https://www.iaisweb.org/page/supervisorymaterial/insurance-capital-standard//file/76133/ics-version-20-public-consultation-document.

3/ See State Farm Mutual's comment letters on Regulatory Capital Rules (Oct. 19, 2012); Capital Requirements for Supervised Institutions Significantly Engaged in Insurance Activities (Sept. 16, 2016); Public Consultation on Risk-based Global Insurance Standard Version 2.0 (October 30, 2018); and Regulatory Capital Rules: Risk-Based Capital Requirements for Depository Institution Holding Companies Significantly Engaged in Insurance Activities (January 22, 2020).

4/ Under the NAIC holding company system acts, which have been adopted by all U.S. jurisdictions, transfers of capital among insurers in a group may be requested, but are subject to strict regulatory approval processes.

5/ Since 2008, the U.S. has introduced a number of regulatory changes in response to risks arising from this type of leveraging. Examples include supervisory college changes, introduction of the U.S. Own Risk and Solvency Assessment, and enhancement of required Enterprise Risk Report (Form F) filings.

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The notice can be viewed at: https://beta.regulations.gov/document/TREAS-DO-2020-0019-0001

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