FEDERAL HOUSING FINANCE AGENCY OFFICE OF INSPECTOR GENERAL FHFA Can Enhance Its Oversight of FHLBank Advances to Insurance Companies by Improving Communication with State Insurance Regulators and Standard-Setting Groups Audit Report: AUD-2013-006 March 18, 2013 March 18, 2013 TO: Stephen M. Cross, Deputy Director of Federal Home Loan Bank (FHLBank) Regulation FROM: Russell A. Rau, Deputy Inspector General for Audits SUBJECT: FHFA Can Enhance Its Oversight of FHLBank Advances to Insurance Companies by Improving Communication with State Insurance Regulators and Standard- Setting Groups (Audit Report No. AUD-2013-006) Summary FHLBanks are cooperatives owned by their members, which include banks, credit unions, and insurance companies. They provide members with financial services involving low-cost funding, called advances, which the members can use for mortgages and other loans. While advances in general have declined in recent years, advances to insurance company members have more than quadrupled. Accordingly, the concentration of advances made to such institutions has increased dramatically. However, lending to insurance companies may present risks different than those associated with lending to other FHLBank members. In particular, there is an absence of uniform federal regulation, and insurance companies are subject to various state laws. To better assess these risks, we examined FHFA’s oversight of FHLBank advances to insurance companies. FHFA recently has taken actions to address risks associated with FHLBank lending to insurance companies by issuing a draft advisory bulletin that identifies risks specific to insurance companies. However, the agency has not addressed two areas that could enhance its oversight. First, neither FHFA nor the FHLBanks coordinate with the state regulators to obtain confidential supervisory or other regulatory information relating to insurance company members. Without such information, assessments of companies’ overall financial conditions and creditworthiness may be incomplete. Second, neither FHFA nor the FHLBanks gather information from National Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 Association of Insurance Commissioners (NAIC) working groups. These groups often evaluate legislative and regulatory actions, emerging issues, best practices, and information sharing opportunities. As a result of FHFA’s lack of coordination with state regulators and NAIC working groups, FHFA may not receive helpful “early warning” information involving state regulatory concerns with insurance companies. Further, it may not be in a position to work collaboratively with state regulators and regulatory support groups when an insurance company member begins to fail, potentially endangering an FHLBank’s ability to recover advances. We therefore recommend that FHFA strengthen its oversight of FHLBank advances to insurance companies by seeking to establish mechanisms to obtain more information from state regulators and NAIC working groups. FHFA provided comments agreeing with the recommendations in this report. Background FHLBanks and Advances The 12 FHLBanks are chartered by the federal government, but owned as cooperatives by their member financial institutions, which include banks, credit unions, and insurance companies. As government-sponsored enterprises, the FHLBanks can take advantage of favorable interest rates to provide low-cost financing to members. Members then use these advances to fund local housing and economic development projects. From 2005 through 2012 the volume of FHLBank advances to insurance companies increased over fourfold from $11.5 billion to $52.4 billion, as depicted in Figure 1. Moreover, as shown in Appendix A, as advances to other members have decreased from 2003, the concentration of advances to insurance companies expanded in proportion to the FHLBanks’ total advances. Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 2 Figure 1: Total FHLBank Advances to Insurance Companies, 2005–3Q 20121 $60 54.9 52.4 $50 48.3 46.8 45 $40 Billions 28.7 $30 $20 14.2 11.5 $10 $0 2005 2006 2007 2008 2009 2010 2011 3Q 2012 As with any loan, providing advances is not without risk. For example, a member could become insolvent and fail to repay an advance. Therefore, the FHLBanks take measures to reduce their exposure to risk, including conducting ongoing financial reviews. FHLBanks also require members to pledge assets as collateral for advances and are typically afforded a blanket lien with respect to a member’s assets in the event of the member’s failure.2 Although being over collateralized and having a blanket lien on assets have worked in favor of FHLBanks when their financial institution members have failed, the concept remains untested for insurance company members. Because insurance companies are not federally regulated, variations and nuances in state laws could reduce the value of their pledged collateral and result in losses to an FHLBank. In addition, insurance companies do not maintain customer deposits guaranteed by the Federal Deposit Insurance Corporation (FDIC), whereas most other FHLBank members do. The FDIC would ordinarily pay off an FHLBank advance if an FDIC-insured member bank failed. However, FDIC would not do so if a member insurance company failed, thus increasing the risk of advances to insurance companies. Member banks must also file a variety of reports detailing their financial condition with the FDIC and other federal regulators. These reports eventually become publicly available and provide extensive individual bank and aggregated information useful for assessing their lending 1 Source: FHLBanks’ annual financial statements, 2005–2011, and FHLBanks’ Financial Summary, Third Quarter 2012. 2 Federal Home Loan Bank Act of 1932 (Public Law No. 72-304). Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 3 risk. In contrast, insurance companies typically file annual financial statements, which are governed by the chief insurance regulators of each state, the District of Columbia, and U.S. territories. These annual financial statements do not necessarily contain regulatory information concerning the insurers’ financial conditions. To date, FHLBanks have not incurred losses from any insurance company members. In the three instances when an insurance company member with outstanding advances failed, the FHLBanks were repaid through the efforts of state regulators before liquidation of collateral became necessary.3 FHFA Oversight of FHLBanks As the regulator of the FHLBanks, FHFA is responsible for promoting their safety and soundness.4 The agency recently has taken some steps to increase its supervision of FHLBanks’ management of advances and collateral, including updating its 2013 examination program with procedures specific to insurance companies. The procedures are intended to assess the adequacy of FHLBanks’ legal support for timely access to pledged collateral, valuation and control of collateral, and evaluation of members’ financial condition. On October 5, 2012, FHFA released for public comment a draft advisory bulletin that identifies risks specific to lending to insurance companies and lists 16 topics that FHFA intends to evaluate through the more specific examination procedures.5 Examiners will consider, among other issues, whether state laws and communications with state regulators substantiate FHLBanks’ timely access to pledged collateral, how FHLBanks assess the financial position of insurance company members, and how FHLBanks evaluate and control pledged collateral. Public comments on the draft bulletin received from key parties—including the FHLBanks and NAIC— suggested a need for improved communication between FHFA and NAIC and state regulators.6 3 In the largest failure to date, Standard Life Insurance Company, a member of the FHLBank of Indianapolis, went into rehabilitation in December 2008. Rehabilitation is a prebankruptcy process in which state regulators attempt to strengthen the company before it is liquidated. With state court approval, the Indiana Department of Insurance arranged for Guggenheim Life and Annuity Company to assume Standard Life’s policies and annuities. The assumption transferred $490 million in outstanding FHLBank advances to a Guggenheim subsidiary, which became an FHLBank member and pledged cash and securities in excess of the advance amount. Similarly, the FHLBank of Seattle incurred no loss on the advance it provided to Old Standard Life Insurance Company after the company failed. Finally, Shenandoah Life Insurance Company, a member of the FHLBank of Atlanta, entered into an Advance Extension and Modification Agreement with the FHLBank. 4 The Housing and Economic Recovery Act of 2008 (Public Law No. 110-289). 5 The bulletin is available at http://www.fhfa.gov/webfiles/24575/77_FR_60988_10-5-12.pdf (accessed February 6, 2013). 6 Comments are available at http://www.fhfa.gov/webfiles/24575/77_FR_60988_10-5-12.pdf (accessed February 6, 2013). In commenting on a draft of the bulletin, OIG noted two primary concerns. First, the proposed advisory bulletin may be inefficient and unenforceable since it imposes standards on FHFA instead of establishing an Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 4 Finding: FHFA Oversight of FHLBank Advances to Insurance Companies May Be Enhanced Through Improved Access to Information from State Regulators and Standard-Setting Groups The effectiveness of FHFA’s changes to its 2013 examination manual will not be evident until the next round of examinations has been completed, but two areas could be improved that may enhance FHFA’s oversight of FHLBanks’ advances to insurance company members. First, FHFA and the FHLBanks do not have a mechanism for acquiring from state regulators confidential supervisory or other information about insurance company members. Second, neither FHFA nor the FHLBanks obtain information from NAIC working groups that are considering issues relevant to the FHLBanks. As a result of FHFA’s lack of coordination with state regulators and NAIC working groups, FHFA may not receive helpful “early warning” information involving state regulator concerns and failing insurance companies. No Mechanism for Obtaining Confidential Supervisory or Other Regulatory Information FHFA’s examination manual for FHLBanks directs examiners to obtain public information on insurance company members to assess their financial condition and trends, but it does not instruct examiners to obtain confidential supervisory information, which would not be publicly available.7 Public information includes annual and quarterly financial reports, infrequent regulatory examinations, information from ratings organizations, and press releases and news reports. Using this information, FHFA can assess general trends and events after they occur. In contrast, confidential supervisory information may include the regulators’ risk reports, results of targeted examinations, potential supervisory and enforcement actions, and information regarding possible or actual fraud. This information may allow examiners to assess risk more timely and thoroughly. In contrast to its efforts in connection with insurance company regulators, FHFA has agreements—memoranda of understanding—with federal regulators of other types of FHLBank members (for example, banks). These memoranda are intended to encourage the sharing of confidential information in recognition of the enhanced oversight it affords. FHFA officials advised us that they are meeting regularly with the federal regulators to discuss improving information sharing. enforceable directive or regulation for the FHLBanks to use when making advances to insurance companies. Thus, the agency is relying on the FHLBanks to establish voluntary measures that will address the identified risks related to insurance company members and help FHFA carry out its supervisory responsibilities. Second, the advisory bulletin is silent as to what, if any, action FHFA plans to take if it determines that an FHLBank’s procedures fall short of ensuring its safety and soundness relative to advances to insurers. 7 FHFA, Examination Manual dated February 2012, Advances and Collateral Module, Description of Risks section, step 10. Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 5 In addition to confidential supervisory information, the examination manual also does not require examiners to obtain any information from state regulators of insurance company members, but instead it advises them to “Review the FHLBank’s efforts to establish on-going communication with federal regulators, particularly with regard to weaker members.”8 This focus on the FHLBanks’ communication with federal regulators is aimed at financial institution members because insurance companies are not regulated at the federal level. Instead, insurance companies are regulated at the state level, and state laws vary regarding rehabilitation and liquidation of troubled insurance companies. Although FHFA has memoranda of understanding in place with federal financial institution regulators, including the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the National Credit Union Association, and the FDIC, it has not attempted to reach similar agreements as appropriate with state insurance regulators. Similarly, FHLBanks do not follow the same information-sharing procedures regarding their insurance company members that they do for other financial institution members. For example, in accordance with statutory requirements, FHLBanks have memoranda of understanding with the federal regulators of most of their financial institution members. These memoranda allow access to confidential supervisory reports and records on regulatory ratings and concerns, risk reports, stress testing, and organizational management, which may help the FHLBanks determine their members’ financial soundness. For insurance company members, however, FHLBanks rely on public information such as general quarterly financial data, basic reports from regulatory examinations (which are sometimes performed as infrequently as every five years), and ratings from nationally recognized statistical rating organizations. These sources of information may be less effective than confidential supervisory information in assessing risks of insurance company members. State insurance regulators confirmed that communication with FHLBanks is lacking. Iowa’s and New York’s insurance regulators told us that they have not shared any internal analyses, communications, or work products with the FHLBanks of Des Moines or New York, respectively, or FHFA. Thus, the FHLBanks would not have access to internal communications or reports of examinations performed by these regulators targeted to specific concerns about financial condition, regulatory noncompliance, or other issues. 8 FHFA Examination Manual dated February 2012, Advances and Collateral Module, Testing section, step 8. Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 6 Lack of Participation in NAIC Working Groups FHFA and the FHLBanks have very limited communication with NAIC, although NAIC working groups and task forces meet regularly to cover several issues key to understanding credit risk of insurance company members.9 Such issues include state and federal legislative and regulatory actions, regulation and examination of insurance companies, emerging issues, best practices, and information sharing among states and federal authorities. For example, NAIC recently established the Receivership FHLBank Legislation Subgroup to consider legislation that could protect FHLBanks’ access to insurance company collateral in the event of insolvency by preventing FHLBanks from being subject to a stay or a voidable preference provision.10 And the 2012 mission for NAIC’s Receivership and Insolvency Task Force included promoting and coordinating multistate efforts to address regulatory strategies for receiverships. Information on NAIC’s decisions and actions on these topics may assist FHFA in assessing the potential risk to the FHLBanks in the event of an insurance company member’s failure. Additionally, NAIC’s Financial Condition Committee recently adopted the “Risk Management and Own Risk and Solvency Assessment Model Act” as of September 2012. This act requires large- and medium-sized insurers to provide a high-level summary report to their primary regulators annually beginning in 2015. The report essentially will be an internal assessment of the risks associated with an insurer’s current business plan and the sufficiency of capital resources to support those risks. Obtaining information through NAIC on available types of information like this report may help FHFA enhance risk assessment of FHLBanks’ insurance company members.11 In a similar vein, in a recent report we recommended that FHFA continue to pursue greater participation in the Federal Financial Institutions Examination Council (FFIEC) to enhance the agency’s coordination with regulatory authorities of FHLBank member banks. The report pointed out that “Coordinating with FFIEC…could increase FHFA’s and FHLBanks’ awareness of issues that impact the safety and soundness of member banks” by increasing “access to sources with the greatest knowledge of issues that may impact the member banks.”12 Consistent with our recommendation, former FHFA Director James B. Lockhart III testified before Congress on June 3, 2009, that “designating FHFA as a liaison member to the FFIEC would facilitate sharing of information with FFIEC members. Because of the importance of mortgage 9 In responding to a draft of this report, FHFA officials informed us in February 2013 that they had recently participated in teleconferences with NAIC staff. 10 Comments from the Insurance Commissioner of the State of Delaware, found at http://www.fhfa.gov/webfiles/24776/6_Delaware_Department_of_Insurance.pdf. 11 NAIC Own Risk and Solvency Assessment Guidance Manual, November 2011, p. 1. 12 OIG, FHFA’s Supervisory Framework for Federal Home Loan Banks’ Advances and Collateral Risk Management (AUD-2012-004, June 1, 2012), available at http://www.fhfaoig.gov/Content/Files/AUD-2012-004.pdf. Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 7 holdings for banks, FHFA should be part of the FFIEC in terms of sharing information and providing input.”13 FHFA agreed with our recommendation, and requested from Congress inclusion in the FFIEC in an advisory capacity, citing “an opportunity to both share information it has on examination and supervisory issues relating to Fannie Mae, Freddie Mac, the FHLBanks and the markets in which they operate and to receive information that might affect these regulated entities.”14 A similar cooperative relationship between FHFA and NAIC concerning the FHLBanks’ insurance company members could have the same benefits.15 In fact, NAIC solicited more dialogue in its public comments on FHFA’s recent draft advisory bulletin, stating that NAIC members “look forward to a more constructive ongoing dialogue in the future.”16 Conclusion FHFA is responsible for overseeing management of counterparty risk. However, FHFA—as part of its enhanced examination procedures—has not put in place formal mechanisms that will help its examiners to ensure compliance with FHFA guidance pertaining to the unique risks posed by insurance company members. For example, FHFA’s FHLBank examination manual instructs examiners to assess whether the FHLBank adequately addressed any increased risk associated with lending to nontraditional members.17 However, FHFA and the FHLBanks do not have access to confidential supervisory or other regulatory information available to the state regulators, such as results of targeted or special reviews, imminent supervisory and enforcement actions, and allegations of potential fraud. Such information could alert examiners to risks they would otherwise be unaware of. Examiners are also directed to determine the adequacy of information used by the FHLBank to assess the financial condition and performance of its members.18 However, FHFA does not have access to confidential supervisory or other regulatory information such as those types mentioned above that the agency would logically consider in its evaluation of whether the FHLBanks are adequately assessing the financial condition and performance of their members. FHFA has emphasized the lack of any losses from FHLBank advances to insurance companies when explaining its actions. Nonetheless, insurance companies, like other FHLBank members, 13 OIG, AUD-2012-004. 14 FHFA’s letter to Congress issued September 13, 2012. 15 OIG, AUD-2012-004. 16 Comments from NAIC, found at http://www.fhfa.gov/webfiles/24714/2_National_Association_of_Insurance_Commissioners_NAIC.pdf. 17 Examination Manual dated February 2012, Advances and Collateral Module, Scope of Examination Work Performed section, step 5. 18 Examination Manual dated February 2012, Advances and Collateral Module, Testing section, step 3. Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 8 can and have failed. And FHLBank advances to insurance company members have increased significantly in both concentration and amount in recent years (see Figure 1 and Appendix A). If those insurance companies begin to fail, the ability of the FHLBanks to recover their advances remains questionable. Formal coordination with state regulators of insurance companies as well as NAIC would aid in fulfilling FHFA’s counterparty risk oversight responsibility by providing FHFA with confidential supervisory or other regulatory information to help assess that risk and reduce potential losses to FHLBanks. With this information, FHFA would be in a position to consider a coordinated response as appropriate with state regulators and regulatory support groups if an insurance company member began to fail. Recommendations To enhance its oversight of FHLBank advances to insurance companies, FHFA should: (1) Pursue memoranda of understanding allowing FHFA to obtain confidential supervisory and other regulatory information from the insurance regulators of states in the districts of those FHLBanks with the highest concentrations of insurance company lending—the FHLBanks of Des Moines, Indianapolis, Topeka, New York, and Cincinnati—to improve FHFA’s ability to evaluate whether the FHLBanks are adequately assessing the condition and operations of their insurance company members. (2) Seek to participate in regular meetings of relevant NAIC working groups to gather information on current and developing issues relevant to the FHLBanks. Scope and Methodology The objective of this audit was to assess FHFA’s regulatory guidance and oversight of FHLBank processes for managing and mitigating risks related to advances to insurance companies. To understand the risks in FHLBank lending to insurance companies and FHFA’s response to these risks, we interviewed senior officials in FHFA’s Division of FHLBank Regulation; reviewed relevant regulations, laws, and other guidance; and reviewed reports, procedures, and selected work papers from FHFA’s 2011 and 2012 examinations of the FHLBank of Des Moines. We chose this FHLBank due to its significant concentration of lending to insurance companies. We also interviewed senior officials at the FHLBank of Des Moines and Iowa’s insurance commissioner and deputy commissioner, and discussed regulation and information sharing with senior officials at New York’s insurance regulator and the FHLBank of New York. We conducted this performance audit from August 2012 to February 2013 in accordance with generally accepted government auditing standards. Those standards require that audits be planned and performed to obtain sufficient, appropriate evidence to provide a reasonable basis Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 9 for the report’s findings and conclusions based on the audit objective. We believe that the evidence obtained provides a reasonable basis for our finding and conclusion, based on the audit objective. cc: Edward DeMarco, Acting Director John Major, Internal Controls and Audit Follow-Up Manager Bruce Crandlemire, Senior Advisor for IG Operations Attachments: Appendix A, Concentrations of FHLBank Lending to Insurance Companies Appendix B, FHFA’s Comments on the Finding and Recommendations Appendix C, OIG’s Response to FHFA’s Comments Appendix D, Summary of Management’s Comments on the Recommendations Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 10 Appendix A: Concentrations of FHLBank Lending to Insurance Companies FHLBank Advances to Insurance Companies as a Percentage of Total FHLBank Advances, 2003–2012 14% 12% 10% 8% 6% 4% 2% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 Q3 2012 Source: FHLBanks’ Financial Summary, Third Quarter 2012. Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 11 Appendix B: FHFA’s Comments on the Finding and Recommendations Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 12 Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 13 Appendix C: OIG’s Response to FHFA’s Comments FHFA provided comments to a draft of this report agreeing with our recommendations and identifying specific actions it would take to address each recommendation. We consider the actions sufficient to resolve the recommendations, which will remain open until we determine that the agreed actions are completed and responsive to the recommendations. Appendix D provides a summary of management’s comments on the recommendations and the status of agreed corrective actions. Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 14 Appendix D: Summary of Management’s Comments on the Recommendations This table presents the management response to the recommendations in OIG’s report and their status when the report was issued. Expected Open Rec. Corrective Action: Completion Monetary Resolved or No. Taken or Planned Date Benefits Yes or No Closedb 1. FHFA will contact state insurance 9/30/13 $0 Yes Open regulators in states and U.S. territories that are within the five FHLBank districts identified in the OIG recommendation. When contacting the state regulators, FHFA will express its overall desire for communication and coordination between state regulators and FHFA, and will request access or a framework for access to confidential supervisory information possessed by those regulators as they pertain to insurance companies that are members of the FHLBanks. 2. FHFA will reach out to NAIC to express 5/31/13 $0 Yes Open interest in formal participation in NAIC working groups. a Resolved means: (1) management concurs with the recommendation, and the planned, ongoing, or completed corrective action is consistent with the recommendation; (2) management does not concur with the recommendation, but alternative action meets the intent of the recommendation; or (3) management agrees to the OIG monetary benefits, a different amount, or no amount ($0). Monetary benefits are considered resolved as long as management provides an amount. b Once OIG determines that agreed-upon corrective actions have been completed and are responsive, the recommendation can be closed. Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 15 Additional Information and Copies For additional copies of this report: Call the Office of Inspector General at: (202) 730-0880 Fax your request to: (202) 318-0239 Visit our website at: www.fhfaoig.gov To report alleged fraud, waste, abuse, mismanagement, or any other kind of criminal or noncriminal misconduct relative to FHFA’s programs or operations: Call our Hotline at: (800) 793-7724 Fax your written complaint to: (202) 318-0385 Email us at: email@example.com Write to us at: FHFA Office of Inspector General Attn: Office of Investigation – Hotline 400 7th Street, SW Washington, DC 20024 Federal Housing Finance Agency Office of Inspector General • AUD-2013-006 • March 18, 2013 16
FHFA Can Enhance Its Oversight of FHLBank Advances to Insurance Companies by Improving Communication with State Insurance Regulators and Standard-Setting Groups
Published by the Federal Housing Finance Agency, Office of Inspector General on 2013-03-18.
Below is a raw (and likely hideous) rendition of the original report. (PDF)