Tuesday, November 09, 2010

Senator Harkin Explains Insurance Exemption from Volcker Rule in Letter to SEC and Urges Regulators to Prevent Hedges from Masking Proprietary Trades

In a letter to the SEC and other regulators, Senator Tom Harkin (D-Iowa) said that the exemption from the Volcker Rule for regulated insurance companies directly engaged in the business of insurance to purchase and sell securities for the general account of the company was included in Section 619 of the Dodd-Frank Act to reflect the reality of the insurance business which requires insurance companies to effectively manage risk over a long period of time. Senator Harkin asked the regulators to recognize that some insurance companies may make investments directly related to the business of insurance through technically more than one account.

So long as these investments are made with premium dollars and used to support claims rather than made to enhance the company’s bottom line, and are regulated by state insurance commissioners, it seems reasonable to the Senator that they be included in the definition of general account within the meaning of Dodd-Frank. The Volcker Rule, codified as Section 619 of Dodd-Frank, generally bans banks from proprietary trading and sponsoring hedge funds. Senator Harkin, currently Chair of the Health, Education and Labor Committee, is a former Chair and current member of the Agriculture Committee and was very involved in issues involving derivatives and hedge funds.

In addition, said the Senator, some insurance companies establish separate accounts to manage the assets of employee benefit plans. So long as these separate accounts are managed for the benefit of those programs and the insurance company’s customers, said the Senator, it seems that those activities may be properly protected by the permitted activity allowing for investments on behalf of customers regardless of whether the insurance company is technically the owner of the assets of the account.

Senator Harkin also said that it will be critical for the SEC and other regulator to use the anti-evasion authority given to them by Dodd-Frank. Specifically, there is a potential for firms to evade the ban on proprietary trading through market making related activities, risk mitigating hedging, and de minimis investments in foreign funds. Senator Harkin said that de minimis seed fund investments in funds should only be of a size so that the funds can develop track records to market to investors. They should not be permitted to become revolving proprietary trading operations.

Senator Harkin also said that the definition of market making related activities must recognize that the goals of market makers and proprietary traders are very different. While market makers provide clients with buy and sell opportunities with minimal risk, proprietary trading is about acquiring risky assets in order to profit when their value changes. Thus, the definition must clarify that firms act as market makers under the Volcker Rule exception when they take a position only for a definite and relatively brief period of time and limit their exposure to that position.

Similarly, the Senator emphasized that risk-mitigating hedging must not be allowed to mask proprietary trading, but rather should be limited to positions taken expressly to reduce a direct exposure to a different positions. Also, regulators must monitor hedging positions to ensure that they are comparable to the original position that is being hedged. He warned that small amounts of exposure should not be justification for an outsized hedge position that could allow a firm to mask a proprietary trade as a hedge.

Effective implementation of the Volcker Rule requires regulators to collect and evaluate large amounts of data on derivative transactions, pricing, the counterparties and how positions are hedged. Senator Harkin urged the regulators to collect some of this data from the swaps and security-based swap data repositories that will be established by the SEC and CFTC pursuant to the derivatives provisions in Title VII of Dodd-Frank.