Press Room
 

October 9, 2007
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Assistant Secretary for Financial Institutions
David G. Nason
Remarks before The National Organization of Life & Health Insurance Guaranty Associations

Amelia Island, Fla. - Thank you for that kind introduction.  It is a pleasure for me to join you here today.  I appreciate the invitation to come back before you to discuss the economy, in which insurance plays an important role, and the credit and mortgage markets.  I also plan to talk about how public policy makers are evaluating and thinking about the regulatory structure of the insurance industry.  Lastly, I will provide a brief legislative update on terrorism risk insurance and share the Treasury Department's perspective on this important topic.

Financial Market Developments

It has been an especially busy time at Treasury.  As you know, there has been an adjustment taking place in the overall credit market and the mortgage market in particular.

Largely because of lax underwriting, the mortgage market, especially the subprime market, has been experiencing a high number and percentage of delinquencies and defaults.  As a result, subprime mortgage-backed securities have performed poorly. 

This has led investors to reassess the risk of these securities and subsequently to reassess price. 

Because of the interrelation of our capital markets, the concerns we have seen in subprime mortgages and related securities have had an impact on investors' confidence and assumptions about the credit quality and value of other assets, especially asset backed securities.

This has lead to a rather widespread reassessment of risk, and a subsequent revaluation across capital markets globally.  Certain asset classes were able to reprice fairly quickly and investors have greater confidence in their fundamental assessments.  In such markets, liquidity has returned and markets are operating in a more customary fashion.  Good examples of these would include most world equity markets, sovereign debt markets, and even investment grade corporate debt.  Alternatively, certain markets are still operating under stress with impaired liquidity.  These would include the jumbo mortgage market, the leveraged loan market, and the asset backed commercial paper market.

In general, the marketplace reaction to some of these excesses has been severe.  Many of the mortgage originators with weak underwriting standards are out of business.  Investors in the mortgage markets are experiencing heavy losses, especially those that failed to perform adequate due diligence to understand the risks of their investments.  We expect the markets to continue to impose discipline on those lenders and investors who took risks without proper diligence.    

We have seen the effects in the financial markets, and it will take some time for these market adjustments to play out.  During this time, our country and the Treasury Department are very fortunate to have Secretary Paulson serving in office.  At the Treasury Department, we have been actively engaged in the situation as it has continued to develop.  Secretary Paulson has been working with financial regulators and with market participants.  At a time like this when risk is being reappraised and market discipline is being imposed, confidence is key.  Having the Treasury led by a Secretary who has spent his life in the financial markets, through good times and bad times, is significant and meaningful.

Given the importance of credit markets to the functioning of our economy, when we experience a fundamental reappraisal like we have over the last several weeks and months, it is not a surprise that this event will have an impact on the economy.  And at the same time, households were already feelings strains from high energy prices and the ongoing slowdown in the housing market after several years of extraordinary gains.  Working in our favor was that the capital markets stress occurred against the backdrop of a strong global economy that has boosted U.S. exports.  Moreover, the U.S. economy went into the credit disruption with some notable positive aspects.  Most importantly, our labor market has remained healthy, with a still-low unemployment rate, ongoing job creation, and sizeable wage gains.  And, business investment has picked up in the middle of 2007 after a slowdown in late 2006 and early 2007. 

All told, the recent reappraisal of risk will result in a penalty to economic growth.  We will continue to analyze this situation.  It will take time for the current reappraisal to work itself out, but in our view the underlying strength of the economy should enable continued growth. 

Housing Impact

Regardless of their eventual impact on the economy, these looming problems are incredibly meaningful to the homeowners undergoing strain.  Therefore, I thought I would take a few moments to share the Administration's current thinking regarding the proper public policy response to these straining times.

We at Treasury are very focused on the difficulties facing many homeowners.  Recently, President Bush, with Secretary Paulson and Housing and Urban Development (HUD) Secretary Jackson, announced an aggressive plan to help as many homeowners as possible stay in their homes and to improve our mortgage finance system for the future.  It is important to note at the outset the principles that we use to approach this problem.  First, our efforts are targeted at homeowners that have the financial ability to own a home over the long-term.  Second, our efforts will not be targeted to speculators that acquired real estate for investment purposes.  Third, we want to avoid bailing out lenders.  Lenders must recognize the value of these impaired mortgages and should not expect government assistance in their commercial transactions. 

This summer, President Bush renewed his call on Congress to pass Federal Housing Administration (FHA) modernization legislation, which would lower down payment requirements, allow FHA to insure bigger loans, and give FHA more pricing flexibility and offer more options to homeowners looking to refinance their existing mortgage. 

The Administration has launched a new FHA program to help people who have good credit but who have not made all of their payments on time because of rising mortgage payments.  For the first time, FHA will be able to offer many of these homeowners an option to refinance their existing mortgage so they can make their payments and keep their homes.  FHA will also charge mortgage insurance premiums based on the individual risk of each loan, using traditional underwriting standards, so it can expand access and help even more families.

President Bush also announced a new foreclosure avoidance initiative to help struggling homeowners find ways to refinance their homes.  Treasury and HUD have begun reaching out to a wide variety of groups that offer foreclosure counseling and refinancing for American homeowners.  These groups include community organizations like NeighborWorks, mortgage lenders and loan servicers, FHA, and Government-Sponsored Enterprises like Fannie Mae and Freddie Mac.  The goal of this initiative is to expand mortgage financing options, identify homeowners before they face hardships, help them understand their financing options, and allow them to find a mortgage product that works for them.

Financial Services Regulatory Review

While Treasury has been focused on these important issues, it has not detracted us from our other important work.  One of the most exciting projects underway involves our examination of the U.S. financial services regulatory system.  As some of you know, earlier this year Secretary Paulson asked the Treasury Department to engage in a broad, ongoing initiative to examine and strengthen the competitiveness of our capital markets.

The structure for regulating financial institutions in the United States generally has served us well.  Much of this basic regulatory structure has developed over time. And while there have been important changes in the way financial institutions are regulated, the Treasury Department believes it is important to continue to evaluate our regulatory structure and to consider ways to improve efficiency, to reduce overlap, to strengthen consumer and investor protection, and to ensure that financial institutions have the ability to adapt to constantly-changing strategies and tools.

The Treasury Department's review of the financial regulatory structure is focused on all types of financial institutions: commercial banks and other insured depository institutions; securities firms; commodities firms; other financial intermediaries – and, important for this group, insurance firms. 

Issues of regulatory structure are not new to you in the insurance industry.  Unlike banks and other financial institutions that are regulated primarily at the federal level or on a dual federal/state basis, insurance companies are regulated solely by the states.  This regulatory approach developed historically from the chartering of insurance companies by state legislatures and the evolution of state tax and insurance codes.  The state-based regulatory approach was reaffirmed in 1945 by the McCarran-Ferguson Act and in 1999 by the Gramm-Leach-Bliley Act, which allowed for greater affiliations across financial firms. 

Many believe that the patchwork of a more than 51-state regulatory system has led to market inefficiencies and that the insurance regulatory structure needs to be modernized to reflect the complexities of today's global marketplace.  The full spectrum of proposals have included:  total federal preemption; dual federal/state systems under an optional federal charter approach; mandating national standards on the state-based system; and harmonizing and making more uniform regulation among the states.

As part of Treasury's ongoing study, the Department is reaching out to experts concerning the regulatory structure of financial institutions in the United States.  These are complicated issues that do not lend themselves to easy solutions.  We plan to release the results of our review, which will include a discussion on insurance regulation, early next year.

We have not made any decisions regarding the recommendations of our regulatory structure review.  However we provided some views on insurance regulatory modernization in testimony before the Senate Banking Committee in July 2006.  Treasury testified that the issues surrounding insurance regulation are significant because the U.S. financial services industry is one of our country's most important areas of economic activity, and the insurance industry is a large part of the U.S. financial sector.  The testimony reflected our focus on three main issues:

  • potential economic inefficiency, resulting both from the substance (such as price controls) and structure of state regulation;
  • international impediments, both questions of comity (facilitating international firms' operations in the U.S.) and competitiveness (facilitating U.S. firms' operations abroad); and
  • systemic "blind spots" – the inability of the official sector to understand and respond to the insurance sector's evolving contribution to risks affecting the financial system as a whole.

Treasury is continuing to monitor closely the developments of the various approaches to modernizing insurance regulation, including proposals to establish an optional federal charter (OFC), which would establish a federal insurance regulator and would allow both life and property/casualty insurers to obtain federal charters.  Many of the largest domestic insurance institutions believe that this approach is better suited to deal with their worldwide operations.  Treasury is interested to see how this approach could potentially address these issues.  We will also focus on approaches that are best suited to provide appropriate consumer protection. 

As you know, the 110th Congress is actively looking at insurance regulation.  In the Senate, Senators Sununu and Johnson have introduced their updated bipartisan bill, the National Insurance Act of 2007; in the House, Representative Melissa Bean and Representative Ed Royce have introduced a bipartisan companion bill. 

Last week the House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a hearing on the need for insurance regulatory reform.

The OFC bills are substantially similar to those introduced in the last Congress, but there are some key differences, including several changes in Title VI applicable to guaranty funds.  Clearly guaranty funds play an important role in the insurance industry by providing a level of protection to policyholders, and they have provided this service well for many years.  Further understanding and refining how the guaranty funds would operate under an OFC model is important to evaluating the overall model.  We look forward to continuing to evaluate this issue in the coming months. 

Another issue in the insurance industry that is related to regulatory structure is the NAIC's efforts to modernize its treatment of reinsurance collateral requirements.  Given the cross border nature of the reinsurance industry, this issue also is directly related to how the U.S. insurance industry interacts with the rest of the world.

Under the current state-based insurance system, a non-U.S. reinsurer can do business in the U.S. by subjecting itself to state-solvency regulation by becoming licensed or creating and licensing a U.S. affiliate or branch in each state it does business; or, by posting 100 percent collateral on its gross U.S. obligations.  For the past several years, non-U.S. reinsurers have pursued changes to the U.S. reinsurance collateral rules on the basis that the rules do not adequately account for the underlying credit quality on non-U.S. reinsurers.  It has been a tortuous process thus far, with most U.S. insurers and reinsurers opposed to any change.  The NAIC has attempted to resolve the dispute by proposing various alternative regulatory regimes, but none have gained any traction. 

The NAIC initiated its latest effort for a solution last month when its Reinsurance Task Force released a new proposal that would revamp the entire state regulatory structure for reinsurance, including but not limited to collateral requirements.  The new proposal envisions a regulatory system for U.S.-licensed reinsurers where one state would be solely responsible for their U.S. regulation.  As to non-U.S. reinsurers not wishing to become licensed or post 100 percent collateral, the new proposal envisions a third option: certification, which would be broadly based on a mutual recognition framework with individual "port-of-entry" states still allowed to set collateral requirements (minimum 60 percent).  The certification requirements are rather complicated and still generating considerable concern among non-U.S. reinsures and foreign regulators.

The NAIC plans to continue its work on the proposal, but as with other recent efforts on reinsurance collateral it remains unclear as to whether it can achieve a solution or if the current state-based regulatory system can be effectively integrated into the global insurance marketplace.  While this is a very technical issue, it is helpful to show the impact that regulatory structure has on an industry's ability to remain competitive in a global marketplace.

Terrorism Risk Insurance

I would like to use the rest of my time here today to talk about terrorism risk insurance.  This issue is being heavily debated in Washington because the current program is scheduled to expire at year-end. 

Following the significant economic dislocation that occurred in the wake of the September 11 attacks, President Bush and Congress responded by passing the Terrorism Risk Insurance Act of 2002, known as TRIA.  TRIA ensured the continued widespread availability and affordability of commercial property and casualty terrorism coverage by basically placing the government in the reinsurance business.   

Temporary by design, TRIA provided time for insurers and others to adjust to the risks made clear by the September 11 terrorist attacks.  Subsequently, there were positive market responses by insurers and reinsurers to the reductions in the federal role over the five years that TRIA was in place.  The most notable one was the increasing role of the private sector in each year of the program.  Insurers increased their terrorism risk exposure as TRIA scaled back, and prices for terrorism risk coverage declined or remained stable.  In some sense, we conducted a market experiment under TRIA that illustrated that the private sector is capable of taking on increasing amounts of terrorism risk as the Federal Government's role recedes.  TRIA generally was effective in encouraging the greater provision of terrorism risk insurance, while at the same time encouraging and supporting private market development. 

Given the success achieved under TRIA to date, the obvious question is whether or not the Federal Government should maintain a limited role in the provision of terrorism risk insurance going-forward.  Based on where the market for terrorism risk insurance is today, it is Treasury's view is that TRIA should continue to be phased out in order to increase private sector participation.  Earlier this year Treasury laid out three critical elements needed if TRIA is to be reauthorized for a second time: 

  • that the program remains temporary and short-term;
  • that private sector retentions are increased; and
  • that there is no expansion of the program. 

Unfortunately, the bill the House passed, H.R. 2761, does not meet these critical elements.  There are some particularly objectionable provisions in the House bill such as:

  • an extension of the program for 15 more years – a de facto permanent extension;
  • the failure to continue to increase private sector retentions;
  • the expansion of the program to add group life insurance; and
  • for the first time, the mandate for insurers to offer coverage for nuclear, biological, chemical and radiological (NBCR) attacks.

I realize that the addition of group life insurance, as well as insurers taking on more NBCR risk may be of particular interest to some in this room.  Let me briefly address those two issues.

As a basic principle, the Federal Government's role in any market, including the market for terrorism risk insurance, should be limited to those areas where private markets cannot function and hence broader costs are imposed on our nation's overall economy. As found by government studies in 2003 and 2006, group life insurance is still widely available in the private market even though it is not part of the TRIA program.  Group life insurers acknowledge that competitive pressures have caused them to make coverage available, even in the absence of TRIA protection.  Thus, the private market is functioning in this area.

With regard to NBCR risk, even prior to September 11, insurance typically does not cover these losses, regardless of the cause, except when mandated by state law, such as with workers' compensation.  Still, TRIA covers insured losses from NBCR losses resulting from a certified act of terrorism if the coverage is provided in the insurance policy.  But it seems clear to us that TRIA has been largely ineffective in spurring the development of a private NBCR market because even with TRIA, there is limited availability.  

While the facts are less than clear that TRIA can help, there are indications that amending TRIA in this way can be harmful.  If insurers must offer NBCR-terrorism coverage, insurer capacity might draw from conventional attack capacity.  Moreover, some insurers are concerned about taking on such exposure and the effect on credit ratings and more importantly their solvency in the event of an actual attack.

Most recognize that the Federal Government is already involved in the sharing of NBCR-terrorism risk given the expectation that uninsured losses will be likely compensated through federal disaster aid programs.  We agree that this is an important and complex issue and acknowledge the absence of a functioning private market for NBCR risks.  However, based on the last five years of experience with the TRIA program, we at Treasury are not convinced that the House's approach will lead to the development of a NBCR market.

These are very significant changes to a program that was designed to be temporary.  For this reason, the Administration noted that senior advisors to President Bush would recommend that he veto the bill.  Despite this, the House bill passed by a wide margin and all eyes are on the Senate.  I am hopeful that the Senate will work toward legislation that addresses the critical elements the Administration laid out so that a scaled-back TRIA program can be reauthorized.

As you can see, we have a number of issues on our plate right now.  These are incredibly interesting times to be serving in the public sector at the Treasury Department.  Thank you for listening and I would be happy to take a few questions.

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