Striking the right balance in industry regulations

The regulatory response to the financial crisis has been unprecedented. In seeking to increase financial stability by preventing a repetition of the crisis, regulators are undoubtedly doing the appropriate thing. However, they must strike the right balance between averting future crises and ensuring that the industries affected can continue to conduct business effectively.

While insurers and reinsurers were not a source of systemic risk during the financial crisis, we are sometimes considered to be systemically relevant, probably because of the complex risks we cover. Undeniably, our business is exposed to many risks – from earthquakes to pandemics. But assessing and pricing these risks, and then absorbing part or all of them, is our daily business. By doing so we help clients preserve their income and deal with the economic impacts of a major loss.

Some supervisors involved in the systemic risk debate believe size matters: Their focus has been on the asset size or the market share of individual institutions as a guide to their systemic importance. We think this approach is not appropriate for insurers and that it is unlikely to identify nor to mitigate systemic risk. Size is a key element in the value proposition of insurers and reinsurers. A global insurance institution has the reach to diversify across different countries, lines of business and unrelated hazards. Also our assets are managed against our liability-driven benchmark triggered by real events.

We believe the supervisory focus should be on risk activities, not institutions. Prudential oversight at the macro level should identify activities with potential systemic risk; supervision at the micro level should address the specific institutions conducting or exposed to those activities. Concentrating solely on institutions creates openings for risk migration, underestimation of systemic risk, market distortions and moral hazard.

Reports: No systemic risk from re/insurance sector

The question that needs to be asked is whether any insurance institutions actually pose a systemic risk. Some observers point to the case of AIG, but the source of its problems was in its Financial Products division, not its insurance activities. If we apply the systemic risk criteria of the Financial Stability Board (FSB), International Monetary Fund (IMF), and the International Association of Insurance Supervisors (IAIS) to banks and then to insurers, we see very different results. In March 2010, the Geneva Association did just that (PDF) and found that traditional insurance activities are not a source of systemic risk. This conclusion has been echoed by other industry observers and government organizations.

It’s the same story with reinsurance: The Group of Thirty (G30) study in 2006 (PDF), also updated in 2010, showed no systemic risk from the reinsurance sector. There is low interconnectedness with the underlying insurance industry, which cannot be compared with the inter-banking market (only five percent of total premiums are ceded to reinsurers). No diversified reinsurer failed during the crisis –and even if one or two large reinsurers would have failed, the G30 concluded that there would have been no knock-on effects from such failures, whether in terms of global insurance market, total capital market or total banking sector. That sounds to me like “no systemic importance.”

Furthermore, a new study by the Institute of International Finance: "The Implications of Financial Regulatory Reform for the Insurance Industry" (August 2011) called for greater cross-sectoral coordination between banking and insurance in regulatory reform. It warned that uncoordinated regulatory reforms will be less effective in promoting financial stability and will undermine the ability of insurers and banks to undertake their core functions in supporting economic activity and recovery  The report urged policymakers to understand the full implications of regulatory reform and take them into account when developing policy.

Far from being sources of systemic risk, global reinsurers remove risk from the system. They act like shock absorbers, smoothing the impact of costly events and injecting capital into the real economy. Only global diversification makes this possible. When the terrorist attack of 9/11 occurred, generating the highest claims ever from any single event, 64% of those claims were paid by international re/insurers. The same can be said of Hurricanes Katrina, Wilma and Rita in 2005. Around 60% of the loss was borne by non-US re/insurers. Without global diversification, the real costs to society would have been far higher.

A stabilising force

The insurance industry also plays an important role as a stabilising force in the financial markets. With a total of USD 23 trillion under their control, insurers and reinsurers have a hand in approximately 13 percent of global assets. Because the insurance or reinsurance business model calls on assets and liabilities to be closely matched, companies like ours usually follow a very conservative and long-term investment strategy, ensuring that the assets under our control help to support the real economy on a long-term basis. If regulations requiring more capital to cover investment risks end up pushing re/insurers away from these strategies, then financial market stability would ultimately suffer through the lack of a powerful stabilizing force.

It may sound like a paradox, but another way insurance companies remove systemic risk is the manner in which they go out of business. The crisis showed that the orderly resolution of companies is a key to financial stability. Here again, the insurance business model differs from that of banks; an insurer has reserves to cover in-force liabilities and future, even unknown, claims. Because it does not have a bank’s immediate liquidity calls, an insurer has time to leave the market in an orderly way, disposing of liabilities and assets over years. In our business, there is often “life after death.”

So, what is a “systemically important financial institution” in the context of traditional insurance? I would say there is no such thing, and that imposing a SIFI framework on insurers conducting core insurance activities will reduce the risk capacity of the insurance industry, endangering its role as risk-absorber and provider of long-term financing to the real economy.

This article originally appeared in Reactions Roundtable Magazine, June 2011

Published 23 August 2011

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