oversight

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)

           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: oighotline@fhfaoig.gov

      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