A look at insurance trends through 2010
If you have a few hours to kill you might enjoy reading the 129-page: Special Report of The Geneva Association Systemic Risk Working Group. The March 2010 report is titled Systemic Risk in Insurance: An analysis of insurance and financial stability. The Geneva Association is the leading international insurance ‘think tank’ for important insurance and risk management issues. This report documents the performance of the insurance industry through the recent crisis and assesses early-stage proposals on systemic risk. The report also “develops initial recommendations to address current regulatory gaps and strengthen industry risk management practices.” We studied the executive summary to learn more about issues in the global insurance space.
No end to financial crisis side-effects
The financial crisis has changed the finance and insurance landscapes forever. At the height of the crisis banks and insurance companies in major Western economies teetered on the brink of collapse, threatening to bring the entire financial system to its knees. As a result governments want more regulation. The report notes: “Among the many proposals under consideration or implementation is the idea of applying more stringent supervision and, perhaps, more onerous regulations to systemically relevant institutions.” Contrary to belief these regulations extend beyond the banking system to insurers.
Insurance industry stakeholders are concerned that regulators will lumber banks and insurance companies with similar regulations. They quickly remind readers that banks (and not insurance companies) were the central figures in the financial system meltdown. Banks, through their incomprehensible lending strategies, created the sub-prime crisis. And banks were hardest hit by the subsequent fallout. Banks also received the lion’s share of the $700trn funding made available through the US Federal Reserve Troubled Asset Relief Programme (TARP).
The Geneva Associations says insurers (without quasi-banking operations) received less than $10bn in direct state support, compared with the $1trn given to banks. American Insurance Group (AIG), the most spectacular of the insurance company meltdowns, was weighed down by its banking activities. “The insurance business model, encompassing both insurers and re-insurers, has specific features that make it a source of stability in the financial system,” they say. Insurance businesses generate strong up-front cash flow from premiums, policies run for lengthy periods and payouts occur in a controlled manner.
Defining systemic risk
The Financial Stability Board (FSB) – not to be confused with the South African regulatory organisation with the same acronym – recently provided a comprehensive definition of systemic risk. The critical factors in an assessment of this risk are size, interconnectedness and substitutability. A fourth condition can be added to this list, namely the speed of loss transmission to third parties. We often forget how complex modern day financial systems have become. Each bank in the US is connected by multiple paths to other banks… And if we view the entire banking system as a network we quickly identify a handful of banks that are vital to banking system transaction stability. The collapse of one important node can bring the entire system to its knees.
The Geneva Association supports this definition of systemic risk, and welcomes the realisation that risk attaches to the activities of the firm rather than the firm. An insurance company that diverges from its core insurance operation by offering banking or other financial services thus creates more systemic risk than the traditional insurance business. At March 2010, the Geneva Association concludes that none of the business activities of the world’s dominant insurers and re-insurers pose serious systemic risk. These activities include investment management (investing policy and shareholder’s funds), liability origination (providing protection and guarantees), risk transfer (through reinsurance, securitisation, etc) and capital management. The association says these transactions pose no systemic risk because:
* Their limited size means that there would not be disruptive effects on financial markets;
* The slow speed of their impact allows insurers to absorb them, such as capital raising over time or, in a worst case, engaging in an orderly wind-up; and
* Features of their interconnectedness mean that contagion risk would be limited.
However, insurance companies that partake in derivatives trading on non-insurance balance sheets or mismanage short-term funding from commercial paper or securities lending could pose risks.
Getting risk reforms right
The Geneva Association believes five measures should be introduced to affect systemic risk reforms in the insurance industry. These include:
1. Implement comprehensive, integrated and principle-based supervision for insurance groups.
2. Strengthen liquidity risk management.
3. Enhance regulation of financial guarantee insurance.
4. Establish macro-prudential monitoring with appropriate insurance representation.
5. Strengthen risk management practices.
The first two measures will address gaps in existing regulation and insurance industry practices, while the next three aim to strengthen financial stability. They conclude: “The industry stands ready to take any action necessary to maintain stability in the insurance system itself, contribute to the stability of the overall financial system, and perform its enabling role in the real economy.”
Editor’s thoughts: The risk of corporate failure in the financially system is higher than in other industries. Dominant banks can take entire sectors of the financial system network down with them. Do you think enough has been done to mitigate financial system risks going forward? Add your comments below, or send them to gareth@fanews.co.za
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