Insurance does not give rise to systemic risk

The core activities of insurers and reinsurers do not give rise to systemic risk; in fact the insurance business model has proved to be a source of stability during the financial crisis. This is the finding of a new report from the Geneva Association, a Swiss based insurance think tank.

The report was commissioned in response to proposals for more stringent supervision of “systemically relevant institutions” in the wake of the financial crisis. Although usually seen as applying to banks, there are suggestions that these new “systemic risk” supervisory regimes should also apply to insurers.

Building on this argument the Association claimed that insurers are not "too big to fail". “Faced with a very large event, an insurer can fail; but, in contrast to what we have witnessed in the banking sector, winding up an insurer is an orderly process that does not generate systemic risk.”

By examining the insurance industry’s performance during the crisis, the Geneva Association developed recommendations to address current regulatory gaps and strengthen the industry’s risk practices.

The report recommended five measures to address gaps in regulation and strengthen financial stability. These include:

1. Implement comprehensive, integrated and principle-based supervision for insurance groups.

2. Strengthen liquidity risk management.

3. Enhance regulation of financial guarantee insurance.

4. Establish macro-prudential monitoring with appropriate insurance representation.

5. Strengthen risk management practices.

The association argued that there are many marked differences between insurers and banks meaning that the two sectors performed very differently during the financial crisis.

“Not only were banks, not insurers, the source of the crisis, banks were also much harder hit by it. Excluding those insurers with large quasi-banking operations, insurers received less than $10bn in direct state support during the crisis, compared with over $1trillion given to banks,” said the report.

Insurance is a stable business model because premiums are funded upfront, giving insurers strong operational cash flow while insurance policies are long term enabling insurers to act as stabilisers to the financial system, claimed the report.

Those few insurers who experienced serious difficulties, most notably AIG, were brought down not by their insurance business but by their quasi-banking activities.

The authors claim that none of the criteria that the FSB uses to assess systemic risk (e.g size, interconnectedness and substitutability) when applied to the main activities of insurance companies pass the test of systemic relevance.

The report said: “We find only two, non-core activities of insurers could have the potential for systemic relevance, assuming that they are conducted on a huge scale and using poor risk control frameworks.” These are: derivatives trading on non-insurance balance sheets; miss-management of short-term funding from commercial paper or securities lending.

Further, the report authors argued that current and already approved insurance regulatory regimes, such as Solvency II, adequately address insurance activities.

“We conclude that principle-based group supervision applied to all entities within an insurance group (regulated and non-regulated), supported by sound industry risk management practices, will mitigate potential systemic risk related to these activities.”

Solvency II should not be confused with Basel II, despite numerical equivalence, said the Geneva Association.

“The consequences of getting systemic risk reforms wrong would not only be severely damaging to the insurance industry but to the economy as well,” concluded the report.