Leading international insurance think tank, The Geneva Association, last week published a special report analysing the role of insurance in financial stability and its systemic relevance. The report has been provided to inform and support supervisors and policymakers in their discussions on the development of measures to address the complex problem of systemic risk underlined during the financial crisis.
In the report, the differing roles of insurers and banks in the global financial system and their impact on the crisis are examined. 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.
Dr Nikolaus von Bomhard, Chairman of The Geneva Association and CEO of Munich Re said, “In the public debate, the business model of insurance is unfortunately not always sufficiently demarcated from the business models of other financial services providers, such as banks. The way systemic
risks are addressed must, however, take account of precisely the specific differences and characteristics of the business models and particular activities carried out by institutions. Just looking at the obvious differences, the conclusion can only be that the insurance industry in its core activities does not pose systemic risks for the economy.”
Patrick M. Liedtke, Secretary General and Managing Director of The Geneva Association said, “The analysis carried out in this Geneva Association report, using the FSB’s criteria for systemic risk, is a positive contribution to the global debate on insurance and financial stability. It demonstrates that the insurance industry is taking an active and cooperative approach to engagement with regulators and policymakers in this matter.”
Dr Stefan Lippe, Board Member of The Geneva Association and CEO of Swiss Re commented, “Global and large insurers and reinsurers play an important role in supporting the global economy, they are shock-absorbers as they have long-term investment strategies. In this respect they contribute significantly to financial stability.”
Andrew Moss, hosting the conference as a Board Member of The Geneva Association and CEO of Aviva said, “The insurance industry with its strong cash flows and well funded customer contracts is a source of stability in the financial system. These recommendations will enhance the regulatory framework, strengthen consumer protection and support the industry's capacity to provide investment to the real economy.”