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New Swiss Re Sigma Study Warns Against A Regulatory Overreaction To The Crisis, Yet Sees Need for Improvement

Source: Swiss Re

Posted on 14 Sep 2010

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While the insurance industry weathered the financial crisis relatively well, acting as a source of stability in the global financial system, the turmoil exposed flaws in the way insurers are regulated. Swiss Re's latest sigma study "Regulatory issues in insurance" finds that improvements could be made to the regulatory environment for insurers, but warns against a potentially damaging overreaction to the crisis. When considering reforms, particular attention should be paid to the supervision of insurance groups, managing liquidity risk and the pro-cyclicality of capital risk charges, the report suggests.

During the financial crisis, the insurance industry continued to operate as usual and insurance regulations were reasonably adequate. With very few exceptions, insurers did not need government support. Nevertheless, substantial changes to the regulatory environment are being considered, which could create distortions in the market that ultimately harm policyholders as well as the economy.

Insurance and banking require different regulatory approaches

Regulatory reform has mainly targeted the banking sector, but some regulations are being extended to the insurance industry in the interest of perceived consistency. Dr. Kurt Karl, Swiss Re's Chief US Economist and one of the authors of the new sigma study, said: "The business model of insurers is fundamentally different from that of banks because their liabilities are not payable on demand, since they generally require an insured event. Also, insurers can fail without threatening the stability of the financial system, since they are not as interconnected as banks and because their liabilities can be run off over an extended period of time."

A major concern stemming from possible regulatory changes is that overly stringent capital requirements could force insurers to make investment decisions that are too conservative, which could lower policyholder returns. Karl added, "From a macroeconomic point of view, such an investment shift would not be desirable for the economy as a whole as it lowers the amount of capital to finance growth."

Effective group supervision is needed

Although insurers fared well during the crisis, the severe problems at a few bank/insurance groups revealed the importance of effective group supervision. The problems invariably stemmed from their banking operations, but affected the entire group.

When the banking operations got the groups into trouble, they were dissolved or required government assistance. Astrid Frey, one of the authors of the study, said: “While the insurance carriers of these groups suffered from the crisis, they remained sufficiently capitalized. Still, this crisis raised awareness that the supervision of insurance groups, particularly those operating across borders, is necessary to understand the overall risk profile of the company." The International Association of Insurance Supervisors (IAIS) has recently started an initiative to make group-wide supervision of internationally active insurance groups more robust and effective.

The importance of managing liquidity risk

During the crisis, liquidity risk, which is not a major problem for insurers, became an issue for some companies as they were forced to obtain sufficient liquidity to meet short-term obligations. Some life insurers had increased their liquidity exposure by lending out an excessive amount of their assets through securities lending programmes without appropriate over-sight, and investing part of the collateral in assets that became illiquid during the crisis. Ratings downgrades of assets or of the (re)insurers themselves also increased liquidity needs. Karl noted, "(Re)insurers need to regularly monitor such potential liquidity requirements based on severe stress scenarios. These scenarios should include a situation where parts of the capital markets become temporarily illiquid, and may need to include a scenario that combines market stress and a catastrophic insured event."

The pro-cyclicality of capital risk charges is a challenge

The crisis also highlighted some pro-cyclical elements in regulatory requirements that are based on market values. When asset prices fall, a downward spiral can occur as some companies may need to sell their riskiest assets to preserve adequate capitalization. This could trigger further price declines, forcing companies to de-risk their investment portfolios further. Frey pointed out, "This is an undesired outcome of some solvency frameworks and should be mitigated when possible. Authorities are working on mechanisms that reduce capital requirements during periods of severe market stress."

Economic and risk-based regulatory frameworks support insurance efficiency and growth

Oversight of the insurance industry is necessary to protect policyholders. Modern regulatory and supervisory regimes such as Solvency II or the Swiss Solvency Test take an economic view and are risk-based. Karl stated, "If implemented properly, such regulations will create an environment in which the insurance industry can operate efficiently and promote financial stability and economic growth."