Systemic Risk - Systemic Risk and Insurance

Systemic Risk and Insurance

In February 2010, international insurance economics think tank, The Geneva Association, published a 110-page analysis of the role of insurers in systemic risk.

In the report, the differing roles of insurers and banks in the global financial system and their impact on the crisis are examined (See also CEA report, "Why Insurers Differ from Banks"). A key conclusion of the analysis is that the core activities of insurers and reinsurers do not pose systemic risks due to the specific features of the industry:

• Insurance is funded by up-front premia, giving insurers strong operating cash-flow without the requirement for wholesale funding;
• Insurance policies are generally long-term, with controlled outflows, enabling insurers to act as stabilisers to the financial system;
• During the hard test of the financial crisis, insurers maintained relatively steady capacity, business volumes and prices.

Applying the most commonly cited definition of systemic risk, that of the Financial Stability Board (FSB), to the core activities of insurers and reinsurers, the report concludes that none are systemically relevant for at least one of the following reasons:

• Their limited size means that there would not be disruptive effects on financial markets;
• An insurance insolvency develops slowly and can often be absorbed by, for example, capital raising, or, in a worst case, an orderly wind down;
• The features of the interrelationships of insurance activities mean that contagion risk would be limited.

The report underlines that supervisors and policymakers should focus on activities rather than financial institutions when introducing new regulation and that upcoming insurance regulatory regimes, such as Solvency II in the European Union, already adequately address insurance activities.

However, during the financial crisis, a small number of quasi-banking activities conducted by insurers either caused failure or triggered significant difficulties. The report therefore identifies two activities which, when conducted on a widespread scale without proper risk control frameworks, have the potential for systemic relevance.

• Derivatives trading on non-insurance balance sheets;
• Mis-management of short-term funding from commercial paper or securities lending.

The industry has put forward five recommendations to address these particular activities and strengthen financial stability:

• The implementation of a comprehensive, integrated and principle-based supervision framework for insurance groups, in order to capture, among other things, any non-insurance activities such as excessive derivative activities.
• Strengthening liquidity risk management, particularly to address potential mis-management issues related to short-term funding.
• Enhancement of the regulation of financial guarantee insurance, which has a very different business model than traditional insurance.
• The establishment of macro-prudential monitoring with appropriate insurance representation.
• The strengthening of industry risk management practices to build on the lessons learned by the industry and the sharing experiences with supervisors on a global scale.

Since the publication of The Geneva Association statement, in June 2010, the International Association of Insurance Supervisors (IAIS) issued its position statement on key financial stability issues. A key conclusion of the statement was that, “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.”

Other organisations such as the CEA and the Property Casualty Insurers Association of America (PCI) have issued reports on the same subject.