The theme of the IIS Annual Seminar at Madrid, Spain, June 6-9, 2010 was “The Aftermath of the Financial Crisis.”  One of the main program issues and one of two research topics included in the Geneva Association/International Insurance Society research program was “Insurance, Systemic Risk and the Financial Crisis.  This leader provides a brief summary of the key elements of the financial crisis and its relationship with insurance.

The recent “Great Recession” started most notably with the long build up of residential housing values (in the U.S. from 2000 to 2006) and the parallel loosening of mortgage underwriting as, particularly in the U.S., public attitude and government policy supported the extension of the “American Dream”, i.e., home ownership, to people with even the most limited of economic resources.  Fueled by low interest rates, this process extended ever deeper into weaker and weaker credit levels.  Other forms of easy credit worldwide helped to sustain this trend.

When the real estate bubble began to lose air, housing values dropped as interest rates increased.  Mortgage payments on variable rate contracts increased as the underlying real estate values dropped, increasingly below the outstanding loan balance. 

The demand for mortgage credit had extended beyond what bank credit resources could satisfy.  Capital markets were tapped through the use of mortgage loan securitization.  Credit risk holding became far removed from loan underwriting.  To enhance investor security, credit default swaps provided assurance (not “insurance” from a regulatory perspective) against creditor default.  As the risk of default grew, issuers of credit default instruments came under pressure to provide reserves and collateral, and to pay off, something generally considered beyond any reasonable expectation by the issuers.  These conditions put pressure on credit markets in general, which put pressure on the overall economy worldwide.

So, what does this have to do with insurance.  Certainly, insurance is part of the general economy and was affected by the general downturn.  But, insurance products were not involved in the credit crisis except secondarily in the form of certain security bonds and coverage of directors’ and officers’ and errors and omissions liability.  Yet, the crisis brought down a prominent insurance company, AIG, that had once been the largest in its field worldwide by market capitalization.  This was not due to its insurance operations, broadly consider among the best managed in the world, but due to the massive exposure of its Financial Products division in the credit default swap market. But AIG’s prominent position in the crisis, along with other financial service conglomerates that included insurance operations, brought the insurance business within the range of businesses for which regulatory review was undertaken.

Insurance is also caught up in the debate for reasons that predate the current crisis.  For many years lines of business once clear among financial services, i.e., banking, securities and insurance, have become blurred.  The repeal of the U.S. Glass-Steagall act in 1999 opened the door to cross-ownership and intermingling of the financial services in the U.S., already combined in many countries.  Commercial and investment banking combined.  Banks offered securities and insurance products.  Insurance relied on capital markets to provide new capital support for coverage, e.g., catastrophe bonds.  As the banking world became more conscious of systemic risk evidenced by monetary crises and their spread across the globe (e.g., 1997-99 beginning in Asia), the response did not involve just the banking world.  The formation of the Financial Stability Forum (FSF), including major national finance ministries and central banks, drew on the leadership of the Basel Committee for banking, the International Organization of Securities Commissions ( IOSCO) for securities and the International Association of Insurance Supervisors (IAIS) for insurance.  The current crisis led to the reformation of the FSF to be the Financial Stability Board (FSB), a more formal international monitor and standard setter for addressing systemic risk including the nations of the G-20.

These conditions have made insurance an integral part of the debate about what to do to prevent future global financial crises.  Concern has grown that rules will be established for financial services that do not recognize the unique characteristics of insurance. 

The recent crisis raised certain questions about the adequacy of risk management controls in financial services in general.  This includes insurance for the reasons noted above.  Risk management is also of particular concern in insurance given its central role in the business of assuming risk.  As a result, risk management has critical strategic potential for new business opportunities from judicious assumption of new risks.

As addressed in more detail in separate leader titled:  “The Impact of Regulatory Change on Insurance Business Strategies and Operations,” insurance regulation and related accounting and performance measurement processes are changing to make them more realistic in terms of risk-based, economic and market  consistent assets and liability valuation.  These trends should improve understanding and accounting for the risks inherent in the business for regulators and the public.  They also require insurers to more carefully manage risk and capital, recognizing increased short-term volatility.

The future of regulatory burden and economic opportunity in insurance will be significantly affected by the pattern and timing of the economic recovery.   The experience to date suggests a gradual recovery over an extended period of time.  Progress could accelerate or deteriorate into a double dip.  The actual course will influence the prospects for the selection of regulatory responses and the economic conditions that will affect business growth and loss trends.  A gradual moving away from a crisis atmosphere may allow for a more measured response, with the critical differences among banking, securities and insurance appropriately recognized.  A return to economic downturn may precipitate broad brush regulatory solutions that are less refined.
Regardless of this path, insurers will need to monitor economic and regulatory developments closely and develop internal analytical analysis to improve understanding of risk patterns and risk selection.  In particular, more attention is required to understand credit risks associated with insureds and reinsurers.  Although use of securitization may require more disclosure of risk profiles, the recent pattern of continued, if muted, use of this access to the capital markets to support risk seems likely to expand the role of capital markets.

What do insurers need to watch for?  It is often true in insurance that the rapid growth in new business, particularly in lines of business or market segments that are not well established, carries extraordinary risk of unforeseen loss experience.  Insurers and reinsurers need to be particularly vigilant in today’s markets where rapid change can provide new insurance and asset accumulation opportunities, often with high risk uncertainty.  Economies can typically absorb and correct for changes in conditions that happen gradually.  It is the sudden shocks that tend to encourage overreaction and steep declines that do much damage and require much time to regain public confidence and recovery.

But, with all of these cautions, it is clear that the new market conditions and changes in regulatory rules will provide significant new business development opportunities that should, with appropriate risk assessment, be pursued.

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