18 February 2010

Published in: Investment risk, Market risks, Regulation - supervision

Do insurers pose a systemic risk?

The case against the banks is pretty damning, given the financial crisis. But insurers? As regulators fret over who and what causes systemic risk, the insurance industry is on the defensive. Jessica Baylis sifts through the arguments over its systemic relevance.

Insurers are not generally considered to be a significant cause of systemic risk to the wider economy. That is the traditional view at least: last November¹ the president of the European Central Bank, Jean-Claude Trichet, told an audience of insurers and regulators that "this view needs to be challenged."

The debate is not academic. As the financial world emerges out of crisis, the new regulatory lines are being drawn up. Containing systemic risk is at the heart of these reforms and the extent to which insurers are hit by the new regulation - something which they are at pains to avoid - depends on how insurers are perceived to be linked to the rest of the financial sector and ultimately the real economy. As Trichet concluded, "we need to have a good understanding of these linkages in order to assess the potential transmission of problems from one sector to another."

An inverted cycle of production

Defining systemic risk is a debate in itself. "Too-big-to-fail," is a phrase often used loosely to describe systemically risky institutions. For a more precise working definition, the following is preferred by the International Monetary Fund and the Financial Stability Board (FSB):

"the risk of disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy."

The argument that insurers do not pose systemic risk is, as Jim Bichard, partner at PwC, explains, centred on the differences between a bank's business model and an insurer's business model. Insurers' businesses are based on an "inverted cycle of production", meaning that premiums are received at the commencement of policies at a price estimated according to the probability of the frequency and severity of events. As a result, "you don't get a run on an insurance company and liquidity is seen as less of a problem because their liabilities and assets are much more closely matched," says Bichard.

Andy Frepp, CEO of Barrie and Hibbert, agrees: "They don't pose the same level of risk to the wider economy." One of the main arguments that insurers do not create systemic risk is that insurance companies are not as directly linked to each other or to other important financial institutions in the way that banks are. Equitable Life which got into trouble in 2000 is a case in point. "It didn't create a systemic problem - it just went into runoff," Frepp notes.

Fear of over-regulation

Carlos Montalvo Rebuelta, the secretary general of the Committee of European Insurance and Occupational Pensions Supervisors, warns, however, that by denying their systemic relevance, the industry may be shooting itself in the foot. Montalvo believes that the insurance industry may be reluctant to concede its systemic importance out of fear for the regulatory implications. With insurers lobbying hard not to be hit by post-crisis banking regulation, the logic goes that the greater the systemic relevance, the more likely they will have burdensome rules imposed on them.

"You don't get a run on an insurance company and liquidity is seen as less of a problem" - Jim Bichard, PwC 

"It is our view that insurers have systemic relevance. This need not have negative consequences; it shows the importance of the sector and shows our relevance at a global level," he says. Montalvo is frustrated that the insurance sector has had very minimal representation and input into the preparations for the new European Systemic Risk Board (ESRB), being set up by the European Commission. "Sometimes our industry has been sending the message that insurers are not systemically relevant but at the same time saying they should be represented on the systemic board. They can't have it both ways."

What are the arguments against the traditional view that insurers do not create systemic risk? Trichet argues that there are three main reasons why insurance companies are important for systemic financial stability.

• First, their size: insurers are very large investors in the financial markets - within the Euro area their investment amounted to €6trn at the end of 2009. According to Trichet, they "have the potential to move markets. In extreme cases, that could put at risk financial stability by triggering large swings in asset prices."
• Second, their interconnectedness: insurers are strongly linked with the banking sector meaning a negative shock to the insurance sector could spill over. Euro-area insurance companies and pension funds hold about €435bn of debt securities issued by Euro-area banks; that's about 10% of debt securities issued. What's more, with European-style "bancassurance" companies, the nature of this spill-over can be direct and immediate.
• Third, their economic function: insurers provide stability to households and businesses thus sustaining the health of the real economy. This enables individuals and businesses to undertake economic activities otherwise considered too risky. This is "a prerequisite for the supply of both labour and capital in most parts of the economy," according to a report by the Basel-based International Association of Insurance Supervisors (IAIS)².

Insurers on systemic risk list

The debate has been fuelled by a list of 30 "systemically relevant" institutions the Financial Times reported to have been drawn up by the FSB. Crucially, the list includes six insurers³. The list is as yet unofficial, although in a press statement, the FSB did acknowledge that, in relation to systemic risk, it is "prioritizing a pool of jurisdictions to engage in dialogue."

Teddy Nyahasha, the group solvency director of Aviva - one of the six insurers - says the company hasn't been contacted by the FSB about any such list. ""We were as surprised as everyone else when the FT printed the article. We are aware of the FSB work on assessing the systemic importance of firms but the existence of the list was news to us."

"Sometimes our industry has been sending the message that insurers are not systemically relevant but at the same time saying they should be represented on the systemic board. They can't have it both ways." - Carlos Montalvo Rebuelta, CEIOPS 

Others in the industry seem equally baffled, says Bichard. "The insurance industry's biggest issue is that there aren't, as far as we know, any criteria for what the FSB constitutes as ‘systemic risk'. By the criteria they think are appropriate, based around liquidity and the impact on the different elements of the financial services sector, insurers don't think they pose that risk but as the list is unofficial, they can't even ask questions."

We must be wary of oversimplifying the question though, believes Dr Shaun Wang, professor and director of actuarial science at Georgia State University's Robinson College of Business. "Most insurers will be impacted by systemic risks, but only a few insurers can contribute to creating systemic risk: we should make this distinction," he argues. "Large complex international players are more likely to contribute to systemic risk, especially those who do a lot of transactions with the banks and those that insure the banks and take capital market risks that are embedded in the products they offer."

Financial products create a regulatory conundrum

Bichard, who believes that insurers on the whole do not pose a systemic risk, does acknowledge that a second dimension of the debate is that "some of the big insurance groups have financial products divisions. It is harder to make the argument that you don't have liquidity risk if you have a credit derivative arm."

This may be true, says Frepp, but then "we're not really talking about insurance companies anymore." In a similar vein, this is how the AIG failure has been explained by the insurance industry - the non-regulated elements were a disaster, but its insurance business was near faultless.

This nevertheless poses a conundrum for regulators. Regulators cannot afford to be so laissez faire in their attitude, Frepp admits. And as Bichard says, "If a group is predominantly insurance and therefore it's treated as insurance with the non-insurance elements being ignored, this is in itself a problem." He argues that regulation needs to be "more specific" to the respective parts of the group: "You need a banking expert looking at the banking part of an insurance group - and insurance experts looking at the insurance. The worst case is that we have banking regulation forced on the whole group."

The regulatory response to this debate has yet to find a consensus, however. Wang, for example, is concerned that Solvency II is not doing enough to address systemic risk. In particular he argues that regulators should not completely outsource the risk modelling to companies.

Regulators should not rely on companies' internal models because they have their own perspective, he argues; only regulators can look at the big picture and review the business model. "I don't think companies' internal models will analyze their own management, their own organizational complexity, or their strategic risk. Regulators should pay attention to those risks because they are more important than some of the technical risks. If you pay too much attention to all the details then you don't see the big picture."

Wang believes it is important for regulators to differentiate insurance companies that pose a systemic risk from companies that do not stray from the core insurance business. "We don't want to create more regulatory burden for companies which are doing well and not causing systemic risk for society." Therefore we need "high level analysis on a company-by-company basis."

Shocks not insurers cause systemic risk

Dr Mary Weiss disagrees that a company-by-company approach is needed. Weiss is an expert in solvency regulation, risk-based capital standards and risk management and is leading the US National Association of Insurance Commissioners' ( NAIC's) effort to understand the impact of the financial crisis on the insurance industry and its implications for insurance regulation. "I think it is important not to focus on a few financial institutions that are ‘too-big-to-fail' as this misses the real cause of systemic risk." The real cause, she says, is usually from an external shock - in 2008 it was the bursting of the housing market bubble. "You therefore have to figure out how to recognize the shocks, how to spot the build up to a shock and how to limit the damage."

"Most insurers will be impacted by systemic risks, but only a few insurers can contribute to creating systemic risk" - Dr Shaun Wang

It is hard to imagine a scenario - with the exception of a bancassurer - where the failure of an insurance company causes havoc in the financial sector which spills over into the real economy, Weiss says. Therefore, insurers must not be considered systemic. "You do have to recognize the insurance industry in creating legislation because they are an important financial intermediary and they are affected by such shocks.," Weiss continues. "But if they're not instigating the systemic risk, then I don't think more regulation is the answer."

Avoiding identifying specific firms appears to be at odds with the IAIS. In the same report, which is aimed at providing input to the FSB on the issue of systemic risk and the insurance sector, it said a "useful" step would be "to identify potentially systemically risky institutions." The same report also warned that identifying the institutions "could create moral hazard and market distortion", which may explain the FSB's reluctance to confirm or deny the existence of a list of "systemically relevant" institutions.

The amplifier effect

The IAIS report on the one hand strongly acknowledges the different business model of insurers while on the other hand making the case for their systemic relevance. The key to its argument is one of timing:

"In the insurance sector the time horizon plays a relevant role, for systemic problems tend to emerge over a longer time horizon than for banking. While banking failures may arise in a matter of hours or days, insurance failures usually take months or years..."

Wang agrees. The sector is huge and insurance companies interact with almost every sector of the economy and facilitate both financial and political stability. "But they have long term contracts. Those long term contracts are systemic risk in slow motion." It is therefore important to consider them in systemic regulation, but not to treat them exactly the same as banks.

So the insurance sector may not have the potential to cause an immediate and dramatic crisis as we saw in 2008, but its systemic relevance can't be ignored. For example, the IAIS report notes that as the insurance sector is one of the largest investors in the world, a sudden decrease in the value of investments or movements of interest rates may affect insurers' liquidity and even prompt fire sales of assets and affect the entire market. "Withdrawal from purchasing financial instruments issued by banks may further lead to a contraction of credit products available in the real economy. Hence, in the area of investment activity, the insurance industry can act as an amplifier of systemic risk."

"Most insurers will be impacted by systemic risks, but only a few insurers can contribute to creating systemic risk" - Dr Shaun Wang 

Weiss suggests making the distinction between companies that create systemic risk and companies that are systemically relevant; insurance companies would fit into the latter category. "This distinction suggests what type of regulation you're looking for." Insurers do not create systemic risk; therefore it makes little sense to burden them with excessive regulation, but because they are systemically relevant, "they should be active participants in formulating the regulation because they will be severely affected by it."

While there is still a lack of a consensus on the precise role of the insurers in the creation of systemic risk, there does seem to be a growing acceptance that it is increasingly difficult to make clear distinctions between the different financial sectors in the realm of regulation. "I think there's a sense that the activities of different entities are blurry and one business can be in one sector and link their activities to various other sectors," Frepp observes.

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