By Victoria McGrane And Leslie Scism 

Life insurer MetLife Inc. on Tuesday sued the federal government over a finding late last year that the firm poses significant risks to the U.S. financial system and should be drawn in for tougher oversight, setting up the biggest test yet of the 2010 Dodd-Frank law.

The lawsuit pits the nation's largest life insurer by assets against the Financial Stability Oversight Council, a group of top financial regulators created by Dodd-Frank and given authority to identify companies that could threaten the U.S. economy in a crisis. MetLife, the fourth company to be designated as "systemically important" by FSOC, is the first company to legally challenge that conclusion.

The fight comes amid a larger battle over Dodd-Frank, which remains under attack from Wall Street and congressional Republicans. Lawmakers in recent months have mounted several successful attempts to roll back or change portions of the law, including eliminating a requirement big banks "push out" certain derivatives trading activities into separate affiliates. Additional efforts are expected in the coming months with Republicans now in control of both the House and Senate. Liberal Democrats led by Massachusetts Sen. Elizabeth Warren are mounting a vigorous campaign to derail even minor changes.

The lawsuit, filed in the U.S. District Court for the District of Columbia, will be a big test of FSOC's power and ability to identify potential financial system threats. The group, which includes the heads of the Treasury, Federal Reserve, Securities and Exchange Commission and other agencies, is supposed to identify financial system risks and take steps to prevent them from building up.

MetLife is challenging the designation as "premature" since the rules governing insurers aren't yet written. MetLife Chairman and Chief Executive Steven Kandarian said in a news release FSOC "should wait until the rules are in place and it knows the impact on designated firms."

The 62-year-old executive has been adamant in recent months that the state-regulated insurer doesn't deserve the designation because if it were to fail, it wouldn't bring down any other companies. Mr. Kandarian has expressed concern that the additional U.S. oversight will result in an unnecessarily fat capital cushion that could drive up product prices and put MetLife at a competitive disadvantage to insurers that won't be held to the same, yet-to-be-determined standards.

"MetLife has always supported robust regulation of the life-insurance industry and has operated under a stringent regulatory system for decades," he said in the release. "However, adding a new federal standard for just the largest life insurers and retaining a different standard for everyone else will drive up the cost of financial protection for consumers without making the financial system any safer."

The government, he added, "should preserve a level playing field in the life insurance industry."

Still, the company's fate as a so-called SIFI has long been predicted. FSOC was created in part over concerns that insurers -- particularly American International Group Inc.-- had fallen into a regulatory abyss and weren't being watched closely enough by the federal government.

AIG got deeply involved in exotic financial instruments that brought it to the brink of collapse during the financial crisis, activity that went unnoticed and unaddressed by the firm's multiple regulators. FSOC designated AIG a SIFI in 2013, along with GE Capital. Regulators tapped another life insurer, Prudential Financial Inc. later that year. None of those firms decided to bring a lawsuit testing the accuracy of the council's assessment.

When the council voted 9-1 last month to apply the label to MetLife, which operates in 50 countries and has about $900 billion in assets, it cited MetLife's size, complexity, links to other financial firms and reliance on complex products. Treasury Secretary Jacob Lew, who chairs FSOC, said in December the decision came "after a year and a half of extensive and in-depth analysis" as well as "significant engagement with the company."

Winning won't be easy for MetLife, which must show that regulators were "arbitrary and capricious" in applying the systemic label to the firm. The high bar stems from a 1987 Supreme Court decision that ruled courts should defer to a governmental agency's interpretation of a statute, legal experts said.

A Treasury spokeswoman said: "We have been notified of MetLife's complaint. The Council's decision to designate a nonbank financial company is reached only after a thorough analysis and extensive engagement with the company, both of which occurred in this case. We are confident in the Council's work."

The threat of litigation has prompted FSOC to proceed cautiously and slowly with its designation powers. The council crafted a multi-step review process, seeking public comment on its approach, even though Dodd-Frank did not require the council to do so. The law requires only that regulators give a firm 30 days to respond. FSOC's process instead gives firms multiple opportunities to engage with regulators and present evidence as to why a designation is not warranted.

Still, MetLife's legal quest is being cheered on by FSOC's many Republican critics in Congress.

"With every reckless designation of a nonbank company as a SIFI, FSOC makes our economy more dangerous and unstable," said Rep. Scott Garrett (R., N.J.), a member of the House Financial Services Committee who has argued that designation amounts to labeling a firm as "too big to fail," or a signal to markets that the government is likely to rescue the firm the next time crisis strikes. "Regardless of the outcome, Congress will continue to make FSOC oversight and reform a top priority in the 114th Congress."

Mr. Garrett and others plan legislation that would subject FSOC generally to more outside scrutiny and change the SIFI designation process. In the face of criticism, the council has launched its own review of how it can improve the process for firms, though its efforts are unlikely to satisfy congressional critics.

The criteria for the designation came from the 2010 Dodd-Frank financial-overhaul legislation that put new clamps on big firms in the wake of the 2008 crisis. The legislation allows any firm labeled as systemically important to challenge that determination in federal court.

The council's conclusion rested partly on concerns that MetLife--were it in financial distress and facing demands from customers to cash in certain products--might have to dump substantial bondholdings from its investment portfolio at fire-sale prices. That could destabilize capital markets and hurt other companies and investors, according to the council's summary of its decision.

The lone dissenter, former Kentucky Insurance Commissioner and insurance lawyer S. Roy Woodall, filed a written objection arguing that other council members relied on "implausible, contrived scenarios" and failed "to appreciate fundamental aspects" of MetLife's products and regulatory controls, he said.

Write to Victoria McGrane at victoria.mcgrane@wsj.com and Leslie Scism at leslie.scism@wsj.com

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