Geneva Association seeks credit for insurers on systemic risk

The association, which is backed by 80 of the world’s biggest insurance groups, is currently chaired by Nicholas Von Bomhard, chairman of Munich Re. It concluded that recent efforts by the FSB and other international bodies to toughen up financial regulations, in response to the credit crisis, should not be applied to insurers in the same way as banks, in a “broad brush” approach.

In a report published on the systemic risk posed by the insurance industry, published last week, the association said that banks and insurers played “markedly different roles” in the financial crisis. “Not only were banks, not insurers, the source of the crisis, banks were also much harder hit by it,” stated the Geneva Association.

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The report found that, apart from insurers with “large quasi-banking operations,” insurers received less than $10bn in direct state support during the crisis, compared with over $1tn given to the banks.

The insurance business model has specific features that make it a source of stability in the financial system rather than risk, stated the report.

These features are that insurance is funded by up-front premiums that give insurers strong operating cash-flow without the need for wholesale funding.

Insurance policies are also generally long-term, that generate “controlled” outflows and enable insurers to act as “stabilisers” to the financial system, said the association.

And, during the crisis, insurers maintained relatively steady capacity, business volumes and prices, it added.

“Those few insurers who experienced serious difficulties, most notably AIG, were brought down not by their insurance business but by their quasi-banking activities. Similarly, the troubled “monoliners” (FSA, AMBAC, MBIA et al.) concentrated exclusively on financial guarantees and CDS writing and trading,” stated the report.

More than 90% of state support to insurers went to those companies with significant and failing non-insurance businesses.

The FSB, Bank for International Settlements and the International Monetary Fund recently gave their definition of systemic risk, which was supported by the G20 finance ministers and central bank governors, and would form the basis of the new, toughened up global regulatory system.

The FSB uses three criteria to assess the systemic risk presented by an institution: size, interconnectedness and substitutability. The International Association of Insurance Supervisors has added time, the speed of loss transmission to third parties, as a fourth criterion.

This is of particular relevance to insurance, as insurance claims, unlike banking obligations, do not immediately generate cash outflows, stated the report.

“We do not dispute these criteria for systemic risk. Even more importantly for the regulatory purposes, they show how systemic risk accrues, not to firms, but to specific activities of those firms,” stated the report.

“The public debate about the business model of the insurance industry is unfortunately not always sufficiently demarcated from the business model of other financial services providers, such as the banks. The way systemic risks are treated must, however, take account of precisely these specific characteristics of the business models and particular activities carried out by institutions,” said Mr. Von Bomhard of Munich Re.

The core activities upon which the FSB bases its measure of systemic risk include investment management (investing policy and shareholder’s funds), liability origination (providing protection and guarantees), risk transfer (through reinsurance, securitisation and the like) and capital management.

According to the Geneva Association none of the insurers pass the test for “systemic relevance” 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; features of their interconnectedness mean that contagion risk would be limited.

The association said that only two non-core activities could cause systemic problems and only if they are conducted on a “huge scale” and based on poor risk control frameworks.

These non-core activities are derivatives trading on non-insurance balance sheets and mismanagement of short-term funding from commercial paper or securities lending, said the report.

The association said that current and planned regulatory regimes such as Solvency II “adequately address” insurance activities.

The remaining question, according to the association, is whether existing regulation adequately mitigates potential systemic risk from these non-core activities or whether it needs to be supplemented or replaced with new measures.

“We conclude that principle-based group supervision applied to all entities within an insurance group (regulated and non-regulated), supported by sound industry risk management practices, will mitigate potential systemic risk related to these activities,” stated the report.

“Solvency II represents such a comprehensive and economic based regulatory framework that it should not be confused with Basel II, despite numerical equivalence,” added the association.

The Geneva Association said that it believes that insolvencies do not need not be avoided “at any price.”

“Faced with a very large event, an insurer can fail; but, in contrast to what we have witnessed in the banking sector, winding up an insurer is an orderly process that does not generate systemic risk,” it said.

The association said that cross-border crisis management is an area that needs “improved coordination” among supervisors.

“In seeking to close remaining gaps in the supervisory framework, regulators should avoid the temptation to place special burdens on specific institutions. This approach could distort the insurance market by skewing pricing, reducing aggregate market risk-bearing capacity, drawing supervisors’ attention away from risky activities going on elsewhere, and creating moral hazards in these ‘too big to fail’ institutions,” stated the association.

The Geneva Association said that the consequences of introducing the “wrong” systemic risk reforms would be “severely damaging” to the insurance industry and the wider economy.

The association recommends five measures of which the first two are suggested to address gaps in regulation and industry practice identified in the report and the remaining three to strengthen financial stability. These are:

1. Implement comprehensive, integrated and principle-based supervision for insurance
2. groups.
3. Strengthen liquidity risk management.
4. Enhance regulation of financial guarantee insurance.
5. Establish macro-prudential monitoring with appropriate insurance representation.
6. Strengthen risk management practices.

“These measures demonstrate the industry engagement to contribute to the discussion on systemic risk. 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,” concluded the Geneva Association.