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PCI Proposes Three-Part Test for Systemic Risk

Source: PCI

Posted on 22 Jul 2009

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In testimony for Tuesday's House Financial Services Committee hearing on systemic risk, the Property Casualty Insurers Association of America (PCI) proposes a three-part test to measure whether a company is systemically risky and determine an appropriate regulatory response.

PCI’s testimony notes that the Obama Administration’s White Paper on regulatory reform is a good starting point for addressing systemic risk. PCI also applauds the administration’s recognition that “the current crisis did not stem from widespread problems in the insurance industry” and that property/casualty insurance is not generally systemically risky. The statement respectfully suggests that Congress consider refining the administration’s proposal to address the probability, cyclicality and economic impact of a firm’s failure rather than whether a company is considered “too big to fail.”

“Size alone does not indicate systemic risk,” says David A. Sampson, PCI’s president and CEO. “For example, a company can be highly leveraged and at-risk of failure but limited in cyclicality or interconnectedness and not affect the larger credit or liquidity market. Or a particular activity could have cyclical risks, but still be so small and unleveraged that it would be unlikely to present a major economic impact. There are many examples, but the bottom line is that a combination of probability of failure, cyclicality and economic impact creates systemic risk, not any of these factors in isolation or based on size. The vulnerability is not found in companies that are ‘too big to fail,’ but rather in those whose activities are too risky, cyclical and interconnected.”

In its testimony, PCI urges Congress to avoid binary systemic-risk classification and use a scalable system to measure this type of risk and meet the challenges it presents. PCI supports the creation of a federal systemic risk overseer and a federal resolution authority to resolve systemically risky companies that are not otherwise subject to federal or state regulatory resolution. PCI also advocates that industries should pay their own risk costs.

“Resolution funding should be assessed separately for each financial industry,” Sampson says. “Industries should not subsidize each other’s activities. Insurers, banks and broker-dealers already have assessment systems to pay for the failure risks generated by their industries. To the extent that activities without government guarantees—such as investment banking, derivatives, etc.—create systemic risks without government guarantees, then those industries should pay their own risk costs and factor it into their pricing. This would minimize moral hazards, cross-subsidies and regulatory arbitrage while reducing market distortion and ensuring accurate risk pricing. It would also limit failures from contaminating other industries, increase the risk pool, and maximize incentives for each industry to work with its own regulator to create the right balance between solvency protection and risk.”

In resolving systemic risks, PCI suggests that the resolution agency should be able to manage a parent holding company’s equity interests but should not be able to reach down into affiliates already subject to separate resolution authority. v “PCI very much appreciates the good work the Obama Administration has done on this issue and in particular its stated recognition that the current economic crisis did not stem from the insurance industry,” Sampson says. “We also commend members of Congress from both parties who are taking on this important issue. We look forward to working with the administration and Congress in crafting sound regulatory reform that addresses systemic risk without pulling in industries that do not present this type of hazard.”