The (re)insurance industry does not pose a systemic risk

Raj Singh, 20 Sep 10

The recent financial crisis highlighted the need for systemic risk monitoring. As a result, systemic risk supervision is likely to increase globally. However, the business model of insurance, which weathered the crisis relatively well, differs fundamentally from that of the banking sector, from which many of the problems during the crisis arose. Insurers and reinsurers, therefore, should not be subject to systemic risk supervision. Group supervision efforts should, however, be pursued.

The crisis showed that some financial institutions were so interconnected with other financial companies that they posed a risk to the entire financial system. Governments are therefore now considering how to regulate financial institutions that potentially could cause systemic crises. Some policymakers believe that insurance companies should be supervised for systemic risk. This viewpoint appears to stem primarily from the failure of one major US insurer. This particular case, however, was not an insurance story.

What are systemic risks?
Systemic risk arises when a financial disruption seriously threatens the economy. The Financial Stability Board (FSB), an international organisation for monitoring financial stability and coordinating financial policies, defines systemic risk “as a risk of disruption to financial services that is, first, caused by an impairment of all or parts of the financial system and, second, has the potential to have serious negative consequences for the real economy.”[1] Systemic risk is a macro-prudential regulatory issue, since it affects the entire economy, while micro-prudential issues are company-specific, eg solvency of an insurer.

What impact did the crisis have on insurers?
The insurance industry survived the financial crisis remarkably well, demonstrating its resilience. Even in the depths of the crisis, direct insurers and reinsurers operated as usual, and most of their clients benefited from stable premiums, adequate capacity and prompt payment of claims. It had sufficient capacity available, even when other sources of capital were unavailable. Government intervention was minimal and mainly needed for non-insurance operations within insurance holding companies.

The impact of the financial crisis was felt most acutely by insurers on the asset side. For example, life insurance companies saw equity capital fall by more than 25% in the course of 2008, although it recovered significantly in 2009. The equity capital of primary P&C insurers was also affected, albeit to a lesser extent, falling by around 15% during 2008 before recovering in 2009. The declines were almost entirely due to the impact of declining asset prices.

Figure 1: Development of equity capital for primary life and P&C insurers (index 2007 = 100)

Development of equity capital for primary life and P&C insurers (index 2007 = 100)

Source: Swiss Re Economic Research & Consulting

Even at the lowest point in terms of capital, (re)insurers continued to write new business as usual (except in credit-related products). Most of the (re)insurance industry’s liabilities were unaffected, though some life insurers were briefly in trouble due to liabilities linked to equity markets – eg variable annuities. Insurance companies that really suffered during the crisis – financial guarantee and mortgage insurers – did not pose any systemic problems and continue to meet their obligations.

What was the relevance of AIG's bailout?
In spite of this stability, the credit activities of one major US insurer increased the focus on the insurance industry. AIG had the largest problems of all insurance companies during the crisis, most of which stemmed from its involvement in bank-like activities. The problem at AIG arose in their Financial Products unit, which sold credit protection through credit default swaps (CDS), which are derivatives not insurance products. This unit of AIG was overseen by the Office of Thrift Supervision, not insurance regulators. Banks were the primary counterparty for AIG’s CDS book of business, so when AIG could not meet collateral requirements for their CDS, the New York Fed and the US government bailed out the firm. AIG’s insurance carriers were impacted by the crisis, but remained adequately capitalised.[2]

How do banks and insurers differ?
The scrutiny on insurance companies as a result of AIG's experiences is unwarranted. Insurance companies, for instance, are funded and create value in a very different way from banks (see Table 1). The nature of their business provides stability to their ongoing operations and to the economy. These differences also help explain why insurers fared better during the crisis than banks. One key differentiating feature is how most of their liability payments are not callable by customers but triggered by pre-defined loss events and paid out over a prolonged period, while bank liabilities are often immediately callable. Because of this, it is very difficult to have a “run” on an insurance operation.

Table 1: Differences between banks and insurers

Issue

Insurers

Banks

Contract characteristics

Insurance only pays a claim when there is an insurable interest (a financial loss to the insured)

Capital market contracts pay whether or not the counterparty has a loss.

Liquidity risk

Insurers have mostly liquid assets and illiquid liabilities. Insurance liabilities are generally triggered by an insured event. However, life savings products can be redeemed, but usually only at a high cost. Insurers have very little short-term funding and aim to match the duration of their liabilities and their assets.

Many of the liabilities of banks — deposits, saving accounts and commercial paper — are short term, i.e. they can be withdrawn at short notice. Many of banks’ assets, e.g. loans, are long-term and illiquid. This liquidity and duration mismatch makes banks vulnerable to bank runs.

Capital buffer

Assets to equity ratios vary widely by company and country, but tend to be about 10 for life and about 3 for non-life insurers.

Banks' asset to equity ratios vary over time, by market and business model, but tend to be higher than in insurance. US commercial banks have recently operated on an asset/equity ratio just above 10. The average ratio of US broker dealers since 1990 has been about 30.

Contagion risk

Insurers do not lend to each other, making them less vulnerable to contagion.

The large size of the inter-bank market makes banks vulnerable to contagion.

Unwinding of global groups

Due to the long duration of liabilities, insurance books of business can be liquidated by regulatory authorities in an orderly manner over the life of the liabilities.

Due to the risk of a bank run, regulatory authorities must often act very quickly to take over a bank to avoid other disruptions.

Source: Swiss Re Economic Research & Consulting

Even when an insurer does pay out a claim, then the timing of the payment, particularly in the case of liability lines of business, as well as property claims, is long. As a result, the (re)insurer's balance sheet remains stable over this period of time. For large property losses, for instance, insurers pay the claims as the reconstruction progresses. As a consequence, insurance books of business can usually be liquidated by regulatory authorities in an orderly manner. In contrast, the bankruptcy of a banking institution may immediately trigger a funding crisis, making it much more challenging to wind down banks in an orderly manner.

Insurance companies also hold different risks compared to banks and size has a beneficial effect for most insurers by allowing for greater diversification of risk. The business of banks is predominantly managing credit risk, which constitutes about three quarters of their retained risk. On the other hand, insurers generally have less than a quarter of their retained risk in credit. Most of insurers’ risk is market risk – primarily from the asset side – and underwriting risks. Reinsurers are the most diversified, with fairly equal portions of credit, market, life and P&C underwriting risks.

Insurers are therefore unlikely to be a source of systemic risk. An institution must be both sufficiently large and well connected to the financial system to pose a systemic risk. Although many insurers and reinsurers are large, none are sufficiently interconnected through their (re)insurance operations to pose a risk to the financial system.

What about non-core activities?
However, there are certain conditions under which the activities of a (re)insurance company might be considered a systemic risk, as shown in a recent, unique investigation conducted by the Geneva Association. Such non-core activities could have the potential to be systemically relevant, if conducted on a huge scale and with poor risk governance as well as poor supervisory oversight. These non-core activities are closer to quasi-banking activities and include speculative derivatives trading on non-insurance balance sheets and mis-management of short-term funding.

What are regulators doing?
The definitions and criteria for systemic risk, as specified by the Financial Stability Board (FSB) and the Bank for International Settlements (BIS), imply that regulations should target specific activities which could pose a risk to stability, not institutions. Focusing on a list of institutions is unlikely to detect or manage systemic risks effectively. Instead, it is likely to encourage risk migration out of the designated companies, permit underestimation of systemic risk, and create distorting moral hazard as designated firms take on greater risk since there is implicit support.

The European Commission proposed that a European Systemic Risk Board be created to take a supervisory role. In a similar vein, the US government is planning a “supervisory board” whose task will be to identify systemic risks. It is envisaged that all systemically important financial companies will be monitored in a consolidated manner.

The problems that arose from AIG's credit protection business revealed a lack of effective supervision of financial groups. Establishing group supervision would mean that large insurers, which are usually organized within a holding company, or group framework, would be overseen by one regulator that is responsible for the entire group. Capital and liquidity requirements would be set for the entire group, taking account of all activities, including non-insurance activities.

In Europe and Switzerland, principle-based regulatory systems with a group supervision concept are being put in place or are already in place. With Europe's Solvency II, which is expected to be operational by 2013, a dedicated group supervisor will look at all the economically relevant entities of a (re)insurance group, including banking operations and unregulated entities. Higher capital charges will be imposed for more risky activities. Under the Swiss Solvency Test, potentially risky activities, such as derivatives trading on non-insurance balance sheets, are taken into account at a group level. This approach helps to ensure that regulators have a more complete picture of the companies under their supervision.

In the US, the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) will affect group supervision of insurers and reinsurers. The Dodd-Frank Act establishes a new Federal Insurance Office (FIO) in the U.S. Treasury Department and this may evolve into a regulator of insurance groups, but currently group supervision is the responsibility of the state where the holding company is licensed. For reinsurers, the Act requires that only the home state regulator of a reinsurer may regulate its solvency. Host states, where a company may be licensed but not domiciled, will no longer have the authority to reach across state borders to regulate for this purpose. This element of the new law is set to become effective in 2011.

Conclusion
Insurers and reinsurers support economic activity in a number of ways. In particular, they promote financial stability, strengthen the social safety net, facilitate trade and commerce, and encourage efficient risk management and mitigation. With the exception of a few individual insurance companies, the industry weathered the financial crisis fairly well. Nevertheless, the failure of AIG has highlighted the need for effective group supervision and measures to guarantee an orderly wind-down of certain international institutions.

Since insurers and reinsurers are very unlikely to pose systemic risk to the financial sector, it would be misguided to subject them to systemic risk supervision that ultimately would duplicate regulatory requirements and restrict their ability to provide valuable services to their policyholders, consumers and businesses. However, because the insurance sector is impacted by systemic risks, the industry supports the introduction of macro-prudential surveillance for financial stability.

Contributors to the article: Astrid Frey and Kurt Karl from Swiss Re Economic and Research & Consulting


[1] International Monetary Fund, Bank for International Settlements, Financial Stability Board: "Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations", October 2009. The FSB was established to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies.

[2] Scott Harrington: “The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation,” The Journal of Risk and Management, Vol. 76, No. 4, Dec. 2009.

Author

Raj Singh

Member of Executive Committee, Chief Risk Officer, Swiss Re

Raj Singh joined Swiss Re in October 2007 from Allianz SE, where he was Group Chief Risk Officer from 2002. From 1989 to 2001, Singh was with Citigroup, where he held a number of senior positions, including Managing Director Risk and M&A for Citibank Northern Europe with site responsibility for Citibank Belgium.  

Mr Singh is a Member of the International Financial Risk Institute and founding Chairman of the Chief Risk Officers Forum. He serves on the Board of two publicly traded financial institutions in the Middle East, Oman International Bank S.A.O.G and Muscat National Holding S.A.O.G., and is a member of the Board of Fellows at Thunderbird School of Global Management and a board member of the Hoerner School Foundation.   

A US citizen born in 1962, Mr Singh holds a Bachelor of Science from the Winona State University, Minnesota, and an MBA from the Thunderbird School of Global Management, Arizona. 

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