The Impact of Systemic Risk in Financial Markets on Insurance
Feb 03.2011 | 1 Comment
1. Is it practical to think that we can devise â€śearly warningâ€ť systems to anticipate future systemic risks or must we focus on being prepared for surprises?
2. How can the insurance industryâ€™s expertise in risk measurement and management be used to better understand risk trends and exposures?
3. Are there new business opportunities for insurers in covering financial market exposures, without being subject to the systemic risk fallout?
4. What dangers does the current low interest rate environment pose for insurers as investors as they seek higher investment returns to meet their obligations?
The recent financial crisis has demonstrated how the failure of individual financial institutions can impact national and global financial markets. Insurance is affected by the resulting systemic risk particularly through its participation in financial markets as an investor, as an insurer of credit risk and liability of actors in financial markets, and as a regulated financial service.
Traditional insurance activities did not generate the systemic risks that exacerbated the recent financial crisis. But, insurers and reinsurers were significantly affected by the impact of systemic risk on financial markets in terms of insured risks, investments, the future basis for financial services regulation, the prospect of new products and improvements in risk and financial management.
Systemic Risk in Financial Markets
Systemic risk in financial markets involves the failure of a significant market segment or segments to function effectively. This may be caused by a particular event (e.g., Asian currency crisis) or a gradual deterioration (e.g., housing value downturn/credit crisis). Expected levels of financial market volatility are priced into asset values. Catastrophic levels of volatility drive buyers out of the market leaving no reliable market clearing price to establish value (apart from limited “fire sale” activity). When assets, used as collateral to secure debt lose value, creditors seek additional collateral. As debtors try to sell reduced value assets to meet collateral calls and capital requirements, market prices are driven down further (i.e., procyclicality). As values fall market actors lose confidence in potential future valuation and the credit worthiness of issuers of instruments generally.
Thus, systemic risk involves extremes of the normal ebb and flow of market optimism and pessimism. When market actors assume that assets will grow in value in the future (e.g., residential housing) they tend to bid up the price now, sometimes resulting in bubbles (i.e., market values in excess of intrinsic value). When actors fear that values will decline, they often overreach in the other direction (i.e., burst bubbles).
Impact on Insurers as Insurers
As insurers, coverage is provided to guarantee certain financial obligations (e.g., monocline credit insurers). Systemic risk poses particular exposure with these products. Even more acute in the recent crisis was the provision of financial guarantees in forms not recognized as “insurance” (e.g., credit default swaps). Insurers also face exposure in E&O, D&O and other markets that backstop financial market participant behavior.
Impact on Insurers as Investors
As major institutional investors, insurers are also exposed to systemic risk extremes. In life insurance and pensions in particular, various forms of retail product guarantees are supported by assumptions of future asset values and returns on assets held by insurers in financial markets. Normal levels of volatility are built into pricing and reserves. The long term nature of most obligations limits life insurer exposure to sudden demands for cash to meet cancelled contracts, but life insurers can suffer significant losses in asset portfolios, particularly when market behavior is outside normal bounds. Occasionally individual life insurers fail due to contractual guarantees that cannot be met with existing reserves or capital, but this rarely involves threats to national or global insurance markets. National life insurance and pension markets have been decimated by hyper inflation in national markets that reduced contract values close to zero (e.g., Eastern Europe with the fall of USSR domination; pension markets in Latin America).
The Recent Financial Crisis and Future Prospects
During the recent financial crisis the U.S. investment banking market illustrated an extreme as a financial market segment highly exposed to the credit crisis. Investment banks relied on daily credit in the billions of dollars to fund investments with debt to equity ratios in excess of 30:1. It doesn’t take very long for a thriving firm to run out of cash if huge reliance on daily credit dries up. This resulted in the failure of Bear Stearns (bailed out) and Lehman Brothers (bankrupt), the acquisition of Merrill Lynch by Bank of America and considerable nervousness at Morgan Stanley and even Goldman Sachs.
The recent financial crisis not only affected financial markets, in term of particular actors and systemic problems. It also led to a general recession. As individuals suffered losses of housing value, jobs and asset values, they had little patience for big bank bailouts because of concern for systemic risk, a little understood idea. To the extent that “bailouts” averted a worse crisis, it is difficult now to explain what might have been. Bank failures may have been averted but high unemployment persists. There is public concern that someone needs to have the tools to anticipate such problems and be prepared to head them off before so much damage is done.
The size and complexity of the recent problems raise doubts that we can prevent future development of financial bubbles or excessive leverage. It is the nature of financial markets to get as much leverage as possible from whatever the current rules allow. Risk taking can be slowed by very high capital requirements for banks and other financial institutions. But very high capital requirements also limit the ability of these institutions to supply needed credit to support economic growth. As in many human endeavors firm managers and regulators are forced to accept a balance that provides incentives to take risk and to innovate for more efficient financial products but limit exposure to extremes. The long history of global financial crises suggests that we are unlikely to be free of them in the future.
Most financial service solvency analysis and regulation is assumes “normal” market behavior and volatility. But, the current concern is less about the “normal” behavior of markets within the known range of volatility. It is the behavior that is outside past experience that is of most concern. This may be just an unprecedented market pattern or may be stimulated by new financial products or actor behavior. What is clear is that the regulatory standards of solvency need to anticipate new and more severe risk patterns than those experienced in the past. Although the approaches vary, most proposed solvency standards involve larger amounts of capital to be maintained against a particular amount of assets, liabilities or financial products.
Insurance and Other Financial Services
Another major issue is how to distinguish the risks of different types of financial activity. Once, “insurance”, “banking” and “securities” were fairly distinct businesses. Today they blend into one another. The good part is that inventive minds seek more efficient ways to manage assets, liabilities and risk. The trouble is that these efforts change the risk exposures, sometimes with unanticipated adverse consequences. In part, these efforts include a preference for regulatory authority and product design that minimizes regulatory capital requirements while permitting increase in leverage and risk. Although some competitors and regulators are now avoiding mixed financial services to limit risks, various forms of bancassurance and other integrated financial services will continue and be further extended. There is a tendency to believe that new innovations in risk packaging and management allow institutions to maintain higher levels of leverage. “This time is different” attitudes seldom last.
Multinational Risk and Solvency
Another concern is to address the increasingly global character of insurance markets. Insurance regulatory systems are generally national, with some “multinational” regimes, e.g. the EU, and some even more segmented systems (e.g., the U.S. state system for insurance). Where inconsistent standards exist there is the opportunity for regulatory arbitrage, i.e., placing insurance operations in a jurisdiction of relatively low standards. The current process of viewing Solvency II as a benchmark standard appears to be leading to greater consistency in standards but the path to global consistency is still long. And the issue is not limited to “insurance.” Consistency and communication among regulators of banking, insurance and securities is needed to avoid problems for regulated entities that arise from less or unregulated activities (e.g., AIG’s non-insurance financial products problems).
Regulator Capability to Meet Regulatory Demands
At least as important as the legal requirements is the approach and capabilities of insurance regulators to enforce the rules. The current trend is toward a “principles-based” approach, where regulatory objectives and guidelines are provided, rather than strict rules. This approach places great reliance on regulated entities to adapt the regulatory objectives and exercise good judgment in applying the principles to firm and market circumstances. Regulators are then required to evaluate each entity’s compliance. Evaluating the exercise of judgment requires much more time and skill than comparing results to a fixed standard. Thus, the future success of solvency systems will require significant upgrades of traditional regulatory staff skills. But will government budgets and agency management be able to step up to this challenge, particularly in a time of heavy pressure to reduce government spending? If not, will the systems revert to unwarranted resistance by regulators to proper self-assessment of risk and self-calculation of capital requirements? Or, will they fail for a lack of adequate regulator oversight or for lack of resources or skills?
Role of Professional Certification and Rating Agencies
One possible way to improve the application of the principles-based rules could be greater reliance on professionals to certify analysis. Company accounts are now subjected to accounting audits with reliance put on audit reports of compliance with accounting standards. Reserves are generally subject to an appropriate actuarial certification. Solvency standards may be subjected to similar professional certification to provide regulators with some assurance of compliance with guidelines. Although not always reliable, rating agencies offer some additional insight into company performance and risks.
Structure of Regulation
Another current debate is about the structure of the broader financial services/economic regulatory system. Should monetary policy be separated from bank regulation in a central bank, or combined? Should banking, insurance and securities be combined in a single regulatory agency? Should prudential regulation be combined with, or separated from, market conduct regulation?
The financial crisis stimulated a new era in global financial regulation. The Financial Stability Forum, a body formed to enhance consistency in regulation of financial services through sector standard setters, including the Basil Committee for Bank Supervision and the International Association of Insurance Supervisors, has now gained a more formal status as the Financial Stability Board, working under the guidance of the G-20 group of nations. In November 2010 the G-20 endorsed Basil III, a new set of banking capital and liquidity standards and monitoring processes and charged the FSB with several implementation steps. The new rules will be phased in over 2011-2019 with provision for revised standards as needed. Part of the charge included identification of Systematically Important Financial Institutions (SIFIs) and requirements for “higher absorbency capacity” for them, recognizing that SIFIs are not easily shut down. FSB is currently working on establishing criteria for identifying SIFIs and the setting of capital and liquidity standards. IAIS is looking into application of these to potential insurance companies on this list. The list is expected mid-2011.
Other topics on FSBs agenda include coordination of resolution laws for SIFIs and needed adjustment to sector core principles of regulation. IAIS is working on a revision of the insurance core principles. FSB is also looking into needed surveillance of “shadow banking,” including less regulated investment banks and sovereign wealth funds. The OTC derivatives market is another area of concern with FSB seeking better information gathering and alternative trading platform structures. Acceleration of the IASB effort to establish a single accounting standard for financial institution is another area of study, including the IFRS project for insurance. Concerns about mortgage underwriting and application of rules to emerging markets are also part of the agenda.
Managing Institutional Power to Precipitate Systemic Risk
Concerns about solvency also raise questions about how to deal with failing institutions. Should institution size and complexity be limited to avoid having one institution with the power to threaten markets systemically? Should lines of business be separated? What powers do regulators need to step in to prevent insolvency or to manage a workout or an insolvency with a minimum of damage? Who should have protection (e.g., a guarantee fund) against loss due to financial institution insolvency?
Compensation and Incentives
Another popular topic of the day is the question of the appropriate compensation of executives and key personnel (e.g., traders). How can financial institutions attract, retain and offer positive incentives to the best managers without then being responsible for unpopular payouts when public support becomes necessary.
New Business Opportunities and Performance Measurement
Finally, although regulation is often considered a burden on the conduct of the business, which adds to its cost, it can also create new opportunities. The current developments in solvency regulation parallel reconsideration of accounting and capital measurement systems that rely more on market-driven, economic measures. The parallel work on the insurance project within the IFRS remake of international accounting standards by the IASB is leading to a more market-consistent, economic approach to measuring risk, capital and performance. The insurance industry has long struggled to measure itself, using separate accounting systems for regulators, tax, general reporting, profitability and valuation. These systems are now converging with either consistent measurement or easier conversion from one to another. The use of internal company models to determine capital requirements may provide a more realistic measure of capital needs, based on business risks, that can be used directly to develop company strategies and the most efficient operating approaches. So long as a “use test” is applied to assure that firms are using such measures in their strategy formation and performance management, this could provide a more realistic basis for regulatory assessment.
The Fundamental Importance of Sound Risk Management
A fundamental prerequisite to these changes is the reshaping of the risk management processes of financial institutions. These must address the full range of risks, normal and extreme, and measure the overall, enterprise, impact of them.
In short, the specter of systemic financial risk has raised many important questions that, together, can lead to a better informed and stable financial system. These efforts can also lead to more efficient, risk-based management of insurance and other financial services.
Sub-topics and Sources:
1. How have the economic crisis and aftermath affected insurance lines, e.g., higher claims, decline in sales, growth in sales, new products?
2. How has the experience in financial services affected the direction of insurance regulation? Is insurance regulation affected by mistaken assumptions about industry needs and norms, e,g., excessive restriction on the use of needed hedging facilities?
3. How will the recent experience change risk management practices in the industry?
4. Will problems in the derivatives markets reduce or change the use of capital markets for insurance activities?
5. What new market opportunities are created by the recent crisis?