Posted on Aug 01, 2012 by Sergio Ulloa
The International Association of Insurance Supervisors (IAIS) recently published a consultation paper titled, "Assessment Methodology for the Identification of Global Systemically Important Insurers". In the paper, the IAIS proposed criteria which will be used to classify insurers as "global systemically important" and invited public comment until 31 July 2012. The paper was endorsed for consultation by the Financial Stability Board (FSB), which has been tasked with coordinating the overall global set of measures to reduce the moral hazard posed by global systemically important financial institutions.
"This proposed methodology results from intensive and thorough discussion within the IAIS based on the expertise from supervisors around the world," said Peter Braumüller, Chair of the IAIS Executive Committee. "Based on a recommendation by the G20 Leaders and the Financial Stability Board, the IAIS has accomplished an important piece of financial sector reform."
The system proposed by the IAIS is very similar to that used by the FSB to identify global systemically important banks, with some modification to reflect the difference in the Insurance business model. The intention is to be able to classify those insurers who have global significance and then, through relevant and effective legislation and continuing oversight, to maximize their stability and to minimize the effect of any financial disaster the insurers may suffer on the rest of the global economy.
Under the proposed IAIS criteria, insurers are categorised according to 18 indicators in 5 broad categories: size, global activity, interconnectedness, non-traditional activities, and substitutability. Four of the five categories are the same as for the banking sector.
The Financial Stability Board, a group of regulators tasked by the G20 nations to establish measures preventing another financial crisis as in 2008, will be using the criteria to examine a total of 48 leading insurers to determine whether they should be placed on a list of "systemic" financial institutions along with leading global banks. AIG, Allianz, Axa and Prudential are all seen as potential candidates for inclusion on the list. Insurers deemed to be high-risk could be forced to hold extra capital under new safeguards being drawn up by the FSB.
The insurance industry supports improved regulation, however, according to the International Association for the Study of Insurance Economics, commonly known as The Geneva Association, the proposed measures are still using too many banking-specific indicators, and have not been adequately modified to account for the fundamental differences between banking and insurance companies. The media and politicians tend to lump insurance and banking together under financial service companies, but the reality is that the two are fundamentally different businesses. In their response to the IAIS proposal on Monday, the Association highlights the fundamental differences between banking and insurance, and argues that research has indicated that the most accurate and efficient method for assessing risk in insurance is to focus on activities, instead of the institution as a whole.
While banks have "callable" funds, in that creditors can claim access to their deposits at short notice, insurers only have liability when an insurable event has occurred. Insurers also receive payment up front, while banks provide credit up front, and receive repayments later.
The difference between insurance and banking is clearly illustrated in how the same criteria indicate different situations for each industry. Diversification and global activity is a good example. In banking, an increase in the size and global activity of a bank means an associated increase in risk and global impact. It is precisely the opposite when it comes to insurers, because insurers use increasing numbers to lower risk.
John Fitzpatrick, the Secretary General of the Geneva Association, elaborates,"We know that if we add more size or diversify by line of business or geography, it further reduces risk. So rather than these being indicators of systemic risk, we think they're indicators of stability and strength."
Size and global activities carry up to 20% weight in the assessment of indicators, but this is contrary to the nature of insurance, since size and global operations decrease risk. The new proposals do not properly take into account the enhanced stability gained by insurers when they diversify into multiple international markets.
"The insurance business is based on the law of large numbers - the larger number of units that you insure, the lower the volatility of the portfolio," explained Geneva Association Secretary General, John Fitzpatrick.
The report points to recent research by The Geneva Association which has identified two activities that do have the potential to create systemic risk as defined by the FSB's criteria, namely speculative derivatives trading on non-insurance balance sheets and the mismanagement of short-term funding. It recommends that, "when collecting data for this methodology, focus should be given to companies engaged in potentially risky activities.
Mr. Braumüller's makes it clear that the IAIS understands this and has taken the different risk profiles into account, "The potential for systemic risk within the insurance sector needs to be considered where insurers deviate from the traditional insurance business model and more particularly where they enter into non-traditional insurance or non-insurance activities."
However, it seems that the Association feels that the considerations don't go far enough. "The system must make the best possible use of regulatory capacity by focusing on activities that can create systemic risks and not misallocate capacity and resources on areas that do not.
We believe that traditional insurance activities should be removed from the process and that noninsurance activities be given a higher weighting than they are currently."
During the financial crisis, the areas in the insurance sector which were directly affected were not related to the primary business of providing insurance coverage, but other non-insurance activities, like banking, credit issuance and mortgages.
The Association agreed that these speculative activities should face tighter controls and higher capital requirements, but stressed that it was important to recognise the difference between hedging against risk (which insurers do as a matter of course) and speculative investing.
The report called for greater clarity in how the IAIS calculated the weighting of the interconnectedness category relative to the banking and insurance industries. Banks in the current banking system are very interconnected, as was highlighted by the LIBOR scandal. However, in their assessment of the banking system, the FSB have assigned 20% weight to the interconnectedness of the institution. Insurers are not nearly as dependent upon each other or so closely connected, yet the FSB have inexplicably assigned a 30-40% weighting to interconnectedness for the insurance industry.
The substitutability measure is also called into question. Insurance products do not require immediate substitutability, unlike in the banking sector where a catastrophic failure in the payment processing and credit facilities of a bank has immediate and systemic impact. The global financial system is not dependent upon the services of insurers and an interruption in insurance coverage of hours or even days would not necessarily create the same kind of consequences. Governments have stepped in before to provide cover during crisis situations, and would be able to do so again without causing systemic interruption.
It is widely accepted that the current string of regulatory changes is a good thing, but the insurance industry is concerned that some of the measures being put in place are either politically motivated, or are being thrown together without due consideration because of pressure from the media, governments and general public. Unintended consequences of regulation can be quite serious, and if we take into account the fact that the FSB is not the only regulatory body pertaining to the Insurance industry, some nervousness in the industry is to be expected. EU officials and industry regulators are currently working through the details of Solvency II, another package of EU-wide regulations set to come into effect in January 2014.
According to a survey by the Geneva Association, 73% of leaders in the insurance industry have significant concerns about the effects of inappropriate regulation. Chairman of The Geneva Association and Chairman of the Board of Management at Munich Re, Dr Nikolaus von Bomhard, said, "The insurance industry plays a vital stabilising role in society and in the world's economies both as a significant participant in financial markets and as a shock absorber for individuals and companies that suffer an insured loss. The results of this survey reveal that leaders of some of the world's largest insurers are concerned that inappropriate systemic risk regulation will needlessly affect our ability to play that role."
About the IAIS: The IAIS is a global standard setting body whose objectives are to promote effective and globally consistent regulation and supervision of the insurance industry in order to develop and maintain fair, safe and stable insurance markets for the benefit and protection of policyholders; and to contribute to global financial stability. Its membership includes insurance regulators and supervisors from over 190 jurisdictions in some 140 countries. More than
120 organisations and individuals representing professional associations, insurance and reinsurance companies, international financial institutions, consultants and other professionals are Observers. For more information, please visit www.iaisweb.org.