The role of insurance in global financial stability – A supervisor’s perspective
20 Sep 2010
The economic crisis of late 2007 and early 2008 highlighted the growing importance of the role of the world’s financial sectors in ensuring global financial stability. The finance industry, however, is not homogenous. Insurers, in particular, have a distinct profile within the industry. This was the subject of leading speakers at the ‘Role of insurance in global financial stability’ event, held at the Swiss Re Centre for Global Dialogue, 29 June 2010. Among other qualities, insurers receive premiums upfront, so are not subject to a run of withdrawals; and through matching liabilities with assets, are long term stabilising investors. There are also distinct challenges in regulating the insurance industry. Some of these were discussed by John Maroney, of the International Association of Insurance Supervisors.
Since I arrived at the International Association of Insurance Supervisors (IAIS) in Basel last September, one of my key tasks has been to assist the IAIS (via its Financial Stability Committee) to develop its views on the implications of the global financial crisis for possible changes to insurance supervision. The insurance industry is an important part of the global financial system and economy. As the international standard setter for insurance, the IAIS has been analysing the potential for financial instability in this sector to determine what, if any, regulatory and supervisory action might be appropriate. Many risks and circumstances where systemic risk might apply to the insurance sector have been examined, regardless of whether these circumstances emanate from the insurance sector or are merely transmitted to the insurance sector from another financial sector.
The IAIS has presented its position on key financial stability issues in insurance, initially in November 2009 and more recently in June, as described in this article. As part of the analysis, the basic insurance business model is described. Following this, the potential for systemic risk to emerge in the insurance sector is discussed. Then the applicability to insurance of recognised systemic characteristics and insurance resolution is considered, followed by some proposals by the IAIS for insurance supervisory enhancements.
Insurance business model
Traditionally the primary purpose of insurance is to indemnify policyholders (both individuals and corporations) from claims associated with adverse events (eg, property damage, premature death, liability claims, etc.) and to provide stable long term savings, including during the future lifetimes of retirees and other policyholders. Diversification of risk is the main tool used in the insurance process; diversification takes place by pooling policyholders’ risks, by insuring a wide variety of policyholder pools, by underwriting in different geographic areas and by diversifying across different types of risks (such as underwriting and investment risk).
To the extent that risk remains after diversification, further mitigation techniques are used by insurers, including reinsurance, hedging, insurance linked securities and the use of certain life insurance products (whereby policyholders take most or all investment risk, often via separate accounts). Generally, insurers incorporate strong risk management practices, including asset-liability management, to mitigate asset and liability mismatches. In addition, supervisory processes and regulatory requirements (such as capital and claim provisioning requirements) help to maintain solvency in the industry. In many parts of the world, there is a strong involvement by the actuarial profession in insurance risk management, with statutory requirements in some jurisdictions for insurers to obtain appropriate actuarial advice and reports.
In spite of such strong risk management practices, insurers sometimes become financially distressed and, in a competitive market, financial distress and insolvencies may occur from time to time. The financial distress of an insurer usually plays out over a long time horizon. That is, assets of the insurer do not need to be liquidated until claims or benefits under the policies need to be paid, and this will not occur until months or even years in the future. Accordingly, regulators usually have the time to intervene to reduce potential losses to policyholders from the insolvency, although this will not always be the case.
Insurers and banks share some common characteristics and risks because they are both financial intermediaries (for example, financial guarantee insurance bears some similarity to banking type products); however, the roles of banks and insurers in the economy differ substantially. That is, banks are part of the payment and settlement system and are involved in the transmission of monetary policy, while insurers are not. Banks tend to rely to a larger extent on short term borrowed money, and hence are exposed to liquidity risk; on the other hand, insurers receive premium payments in advance of claims so that liquidity risk is not usually an issue but can be so if large borrowings have been utilised to finance acquisitions or rapid organic growth.
Systemic relevance and systemic risk
The insurance sector is susceptible to systemic risks generated in other parts of the financial sector. For most classes of insurance, however, there is little evidence of insurance either generating or amplifying systemic risk, within the financial system itself or in the real economy. This is because of the fundamentally different role of insurers in the economy as compared to banks. It is important also to note the stabilisation role that the insurance sector typically plays in the economy that may help to limit systemic risk. This stabilisation role was an important factor during the financial crisis, as the majority of insurers were able to withstand the fluctuations in capital markets, without having to resort to fire-sales of assets or similar drastic actions.
The G20, International Monetary Fund (IMF), Financial Stability Board (FSB) and Bank for International Settlements (BIS) reports have focussed on three characteristics of systemically important financial institutions: size, interconnectedness and substitutability. These characteristics warrant careful inspection from an insurance perspective.
By itself, size is not a particularly good measure for assessing the potential for systemic risk in insurance. In fact, size has a beneficial effect for most insurers by allowing for greater diversification of risk (via the law of large numbers). Also, because premiums are funded in advance of claims, insurers typically are required by operation of the business model and regulatory requirements to have a large amount of assets on hand relative to liabilities in comparison to banks, which can be critical in the event of an insolvency.
Reinsurance activities help redistribute risks among insurers; but also contribute to interconnectedness within the insurance sector. Hypothetically, failure of a large reinsurer and/or a reinsurance spiral could conceivably have a significant impact on capacity among primary insurers and cause disruption to the real economy (although neither such occurrence has occurred to date). IAIS monitors these potential risks with its Global Reinsurance Market Report, which has shown that reinsurance risk exposures have so far been well managed and diversified.
Insurers are interconnected with financial and non-financial firms, including through equity shareholdings, corporate debt holdings, other investments, treasury operations, securities lending. However, whether these interconnections are of systemic importance would depend on how much the total exposure of insurers’ investments account for in the overall economy. Further, as already indicated, immediate liquidation of an insurer’s investments does not occur when an insurer becomes insolvent. Hence, a fire-sale of large blocks of investments which might depress asset prices does not typically occur in the insolvency of an insurer.
Lack of substitutability in the insurance sector may lead to market disruptions, especially when insurance coverage is necessary to conduct business. For example, a market disruption can occur when compulsory or widely used insurance products become unavailable. This occurred in Australia following the failure of the country’s second largest insurer, HIH, in 2001; and to some extent after the World Trade Centre attacks in 2001. Also, insurance against catastrophes can become unavailable or extremely costly after a catastrophic event. There is also a possibility that a market failure will occur where insurance capacity disappears in a particular segment of the insurance market, such that parts of the real economy are disrupted and government intervention is required. Market disruptions or failures of this nature are typically relatively short term, as new insurers and/or reinsurers can usually move into the affected region to create capacity for the product(s) in question, although this is not always the case. An effective regime of regulation and supervision can help mitigate this possibility.
An important part of the IAIS analysis has been exploring ways in which insurers may amplify systemic risk under certain circumstances. For example, the participation of life insurers in capital markets can contribute to selling pressure, if the insurers collectively hold significant positions in equities, bonds or hedging instruments and need to liquidate their positions simultaneously in a falling market.
Of course, as conditions change in the future, in theory the possibility exists that insurers may become systemically important. Some cases where insurers might generate systemic risk include: (1) widespread distribution of financial products that contain a minimum guarantee and/or distribution of other types of banking-like products; (2) widespread (naked) derivatives trading, especially extensive distribution of credit default swaps (CDSs); (3) expansive offering of financial guarantee insurance; and (4) insurers using regulatory arbitrage to offer products or services that end up being systemically important.
Indeed, the nature of the insurance industry has already been changing. Some parts of the industry have been growing in complexity, diversity and global reach. Financial innovation and the rapidly changing financial environment have contributed to the formation of some insurance entities and groups spanning jurisdictional borders and/or sectors. In light of continuing financial instability since 2007, there has been an increased focus, by many parties, on issues of financial stability and the risks associated with large and complex financial organisations operating on a cross-border and/or cross-sector basis. This is a major concern of the FSB and G20 discussions and will be one of the key issues considered by G20 Leaders during their summit in Seoul in November.
Of particular concern has been the potential risks emerging from non-regulated entities of financial conglomerates (as in the case of AIG) and some insurance activities (such as financial guarantee insurance) which can generate or amplify systemic risk and may be instrumental to contagion within conglomerates or between sectors. Further, contagion effects might also occur if a member of a group exhibits financial distress.
The ease with which an insolvent insurer can be resolved depends on many factors, including the role of insurance guarantee schemes, where they exist. For insurers (unlike banks), there can be ‘life after death’. That is, failed insurers often can be managed through orderly run-off, and sometimes even brought back to life with new capital.
All insurers are regulated at the solo entity (company) level. However, there is widespread recognition that the resolvability of internationally operating financial entities, groups, or conglomerates poses significant legal challenges. Enhanced supervisory oversight for such entities is underway and cooperation with other sectors will be required.
Again, this is another major concern of the FSB and G20 discussions and will be considered by G20 Leaders in November, when they focus on how to better control systemically important financial institutions.
Proposed supervisory enhancements
The IAIS agrees that it is necessary for insurers and insurance groups to be supervised on a solo entity basis and on a group-wide basis. Group supervision should include consideration of non-regulated entities and/or non-operating holding companies within a group. Other supervisory enhancements are under consideration and/or development (particularly in cooperation with the Joint Forum) to reduce the potential for regulatory arbitrage. These enhancements should reduce the probability and potential impact of future insolvencies and insurance market failures. The enhancements should increase the role of insurers as stabilisers and decrease their potential susceptibility to systemic risk or their roles as potential transmitters or amplifiers of systemic risk. The enhanced insurance supervisory framework should contribute to financial stability and should also improve micro-prudential supervision and policyholder protection.
Since interdependencies between the sectors may increase in the future through products, markets and conglomerates, the IAIS is promoting enhancements to supervision and supervisory processes, combined with stronger risk management and enhanced approaches to resolvability to minimise adverse externalities. These enhancements include group-wide supervision and the development of a Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame). The IAIS is also promoting cross-sectoral macro-prudential monitoring of potential build-up of systemic risk and planning to develop measures for national authorities to assess degrees of systemic risk.
In particular, ComFrame will develop methods of operating group-wide supervision of Internationally Active Insurance Groups in order to make group-wide supervision more effective and more reflective of actual business practices; establish a comprehensive framework for supervisors to address group-wide activities and risks and also set grounds for better supervisory cooperation in order to allow for a more integrated and international approach; and foster global convergence of regulatory and supervisory measures and approaches.
Clearly, there are many challenges on the insurance regulatory reform agenda in the months and years ahead. Hopefully, these challenges will be successfully faced both by supervisors and insurers and both policyholder protection and financial stability will be enhanced.