19 January 2010

Published in: Regulation - supervision

Insurance regulation will stay lighter-touch than the banks’

Insurers came through the financial crisis relatively unscathed and don't pose systemic or liquidity risks, argue Jonathan Hekster and Toby Langley

On December 17, the Basel committee announced measures to strengthen the resilience of the banking sector in the face of crises like 2008. These measures will curtail the operational freedom of banks and drive up their capital requirements.

So what impact will the 2008 crisis have on insurance regulation, particularly given the continuing process of introducing the risk-based Solvency II framework?

We believe that the regulatory framework for insurers will remain lighter-touch than that of the banks, which is a positive for insurance vs. banking stocks.

Our view is based on several arguments:

• Insurance companies came through the crisis relatively unscathed, particularly in Europe. With the exception of Swiss Re and AEGON, none of the European insurers has had to resort to massive recapitalization. Insurers remained in decent shape both in solvency and liquidity terms.
• Solvency did not turn out to be a problem as insurer leverage and exposure to risky assets were lower than for the banks. Insurers, with the exception of AIG, AEGON and Swiss Re, did not really develop the kind of leverage and impairment risks that the banks were exposed to. However, regulators should make sure we avoid the risk of "mission creep" seen at AIG.
  
  European insurer balance sheets and solvency strength held up pretty well during 2008 and 2009. Based on the publicly reported solvency positions most insurers never quite got close to breaching their regulatory required solvency levels.
  
  The European insurance sector did see some partial recapitalizations (AEGON and Swiss Re notably) and dividend cuts (Zurich, Aviva and L&G) but this was a stark contrast to the widespread capital raises seen in the banking sector.
  
  RBS's April 2008 rights issue of £12bn alone was more than the cumulative capital raised by all European insurers in 2008. The two recapitalization cases occurred at the extremes of the universe in terms of investment exposure and balance sheet leverage:
• Historically, post-crisis regulatory change has been less onerous for insurers.
• Insurance companies do not pose liquidity risks like the banks. Their short-term liquidity pressure is marginal. In fact, life insurance companies in particular have higher cash flows if they get into trouble. Life insurer cash flows can be boosted in this situation because they are often able to charge lapse fees to policyholders that want to make withdrawals from their accounts. Insurers also gain a boost to cash flows by restricting or ceasing the payment of high commissions on new business. Non-life companies receive premiums up-front and pay out claims later, sometimes many years later, so again there is no real immediate cash pressure.
• Insurers do not really pose short-term systemic risks. Despite the inclusion of six insurers on a recent Financial Stability Board list of systemically important cross-border financial services institutions we believe that in reality insurers can easily fail without disrupting the global economy. The rationale for including insurers on the list (no availability of insurance cover following a big loss) is feeble and no comparison to risks banks pose in a systemic sense.
• Life insurers have some flexibility to reduce client returns if yields are insufficient; thus they rarely really default but typically end up in an orderly run-off.

Jonathan Hekster and Toby Langley are research analysts covering the insurance sector at Sanford C Bernstein in London

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