Lawmakers will hold their first hearing Tuesday on an issue that has largely mystified regulators: how to craft capital rules for insurance companies.

It is one of the biggest unanswered questions of the post-financial regulatory system nearly four years after the passage of the Dodd-Frank Act, and has been raised frequently at other hearings on Capitol Hill. But regulators have thus far provided no clarity.

At issue is how the Federal Reserve Board will interpret a universal capital minimum in Dodd-Frank, authored by Sen. Susan Collins, R-Maine, for insurance giants that fall under the Fed's watch as a result of new powers to supervise nonbanks. The central bank has signaled that it is willing to tailor capital rules as best as possible for insurers, but have repeatedly acknowledged they face constraints in how regulators must implement the Collins Amendment.

But lawmakers such as Sen. Sherrod Brown, D-Ohio, who will chair next week's hearing before his Senate Banking Committee subcommittee, want the Fed to be more flexible. His hearing will feature testimony from Collins, who agrees the Fed should take a lighter approach.

"The regulators have said all the right things. The rhetoric is great, but you still have to get around the language of Dodd-Frank and the Collins amendment. It's a very tough standard, it is a very well-articulated standard," said Brian Gardner, a policy analyst at Keefe, Bruyette & Woods.

Under the reform law, the Financial Stability Oversight Council has the power to name nonbank firms as systemically risky, but it is up to the Fed to decide how to supervise those institutions. To date, FSOC's designations have included two insurance powerhouses — American International Group and Prudential Financial — and others are said to be under consideration.

Also see Why the Fed Won't Say How It Will Regulate Nonbank SIFIs

The Collins amendment was intended to apply bank-like capital requirements to larger firms under the Fed's purview, including bank holding companies. But lawmakers, even those who supported Dodd-Frank, are claiming the capital floors were not meant for other types of firms.

"It's an effort to put more pressure on the Fed to change its view on the Collins amendment as the binding threshold and how easy it can be on the big insurance companies," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc.

But Petrou added that a weakening of the requirement appears unlikely.

"I do not think the Fed will change its mind, absent a change of law," she said.

Last month, the central bank delayed addressing the issue, instead putting forth two options on how it could proceed. The Fed said regulators could either draft a separate rule laying out how the Collins amendment would treat nonbank financial companies designated by FSOC, or issue an order for each firm based on a particular threat the Fed may perceive.

But top officials at the Fed have repeatedly pointed to the Collins amendment as limiting the central bank's discretion to provide flexibility.

"I think it's important to note that we do operate under a constraint here," said Fed Gov. Daniel Tarullo at a Senate Banking Committee hearing on July 11. "It, that is to say that the Collins amendment does require that generally applicable capital requirements be applied to all of the holding companies that we supervise."

Last summer, former Fed Chairman Ben Bernanke, testifying before the House Financial Services Committee, went further. He suggested to lawmakers that a legislative fix would be the best solution to mitigate the effects of the Collins restrictions on nonbanks.

But Brown along with others are expected to make the case that the Fed has the ability to take a more flexible approach without an intervention by Congress, while still adhering to the spirit of the law, according to a Senate aide.

"Sen. Brown believes that insurance companies that focus predominately on these services should not have to face the same capital standards needed to protect our financial system from ‘Too Big to Fail' megabanks," said Ben Famous, a spokesman for the senator.

But Gardner argued that if the Fed had found a loophole, they would have already issued a proposal on the matter.

"If there was an easy way to get around this they would have found it by now," said Gardner. "It's taken them a long time, which suggests to me that there is no easy answer."

Meanwhile, Collins is expected to reiterate at the hearing her view that the provision was not meant to impose bank-like standards on firms like insurance companies.

"It was not Congress' intent that federal regulators supplant prudential state-based insurance regulation with a bank-centric capital regime," Collins wrote in a Nov. 26, 2012, letter to the three top bank regulators. "For example, banks and insurers typically have different composition of asset and liabilities, since it is fundamental to insurance companies to match assets to liabilities, but this is not characteristic of most banks. I believe that it is consistent with my amendment that these distinctions be recognized in the final rule."

But top Fed officials have disagreed, arguing that while regulators can and will take into account different characteristics of insurance products that are not marketed by banks, they are limited in other areas such as risk-weighting.

"We don't have the ability to risk weight, for example, the same security that's held by a bank or by an insurance company differently," said Tarullo at the July hearing. "And at some level [it] doesn't really make sense to do it differently. The asset has the risk that it has."

Brown, along with Sen. Mike Johanns, R-Neb., drafted a bill that would clarify the Collins amendment by exempting insurers from the Fed's capital regime for banks while still leaving intact its ability to impose capital standards on insurance companies. The legislation has received bipartisan support from 20 cosponsors.

In addition, the bill would also ensure that Basel III bank capital standards would be appropriately applied to institutions owned by an insurance firm.

Last July, regulators postponed applying Basel III rules to insurance companies, and have been in negotiations with the industry on how to revise the global framework to meet such firms' business models.

That's partly why the debate over the Collins amendment could be a turning point for how the Fed proceeds. Presumably, any changes or signs of flexibility by the Fed on the provision could signal how sympathetic it may be in crafting other rules.

"If the Fed changed its view on Collins, the Fed would be much more lenient on the Basel III rules," said Petrou.

This story first appeared at American Banker.

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