The Financial Stability Board (FSB) has completed its framework for the regulation of systemically important banks (FSB 2013a), and is now turning to the insurance industry. Its approach is inspired by the banking framework, under which 29 banking groups have been classified as systemically important. These banks are subject to a three-pronged framework consisting of enhanced supervision, the preparation of risk- and crisis-management plans, and the application of capital surcharges.
The regulators are pursuing a similar three-pronged strategy for the nine insurance groups designated systemically important in July 2013 (FSB 2013b): five insurance groups from Europe, three from the US, and one from China. Progress is underway: supervision has already been enhanced, risk-management plans are under preparation, and the global community is currently working on a framework of possible capital surcharges.
Motivations for global insurance regulation
There are a number of motivations behind recent efforts to implement global regulation of the insurance industry (Thimann 2014a). Five stand out:
1. Given the historic severity of the global crisis, only the widest possible regulation of financial institutions is politically acceptable.
2. Some insurers experienced financial distress in the crisis, and a few of them required government support. In addition to the case of AIG, two US insurers required government support, as well as one in the Netherlands and one in Belgium. The total support provided to these insurers amounted to about €7 billion (compared with several hundred billions of euros in support for the banking system in Europe and billions of dollars in the US).
3. AIG – a company known by the public as an insurer – was the largest bailout in history. AIG received an $85 billion loan from the Federal Reserve and subsequently received $100 billion in support from the Treasury. This suggested that insurers could be as systemic as banks, if not more so.
4. Insurers are large-scale financial intermediaries between savers and investors in the economy, and they are important investors in financial markets. Even though the size of insurers’ balance sheets in most economies is well below that of the banking sector – about €6 trillion in the Eurozone, compared with €30 trillion for the banking sector (Figure 1) – insurers represent a significant part of the financial system and play an important role for the real economy.
5. Since banks, which are also financial intermediaries and financial investors, are subject to global regulation and systemic regulation, it might seem logical to apply the same principle to insurance.
Figure 1. Banks’ and insurance companies’ balance sheets
Source: European Central Bank.
Notes: Main balance sheet components of the Eurozone’s aggregated banking system and insurance sector. The size of each box corresponds to the relative weight on the balance sheet. The total absolute values shown also include external assets and liabilities, fixed assets, and other assets and liabilities that are not represented for the sake of simplicity. A unit-linked insurance plan is a type of life insurance where the value of a policy is linked to the net asset value of the underlying investment and where customers are allocated units, as in a mutual fund.
Challenges for global insurance regulation
While motivations are relevant and manifold, so are the challenges for global insurance regulation. The following challenges stand out:
1. Insurance is a less global business than many parts of banking and other financial activities such as brokerage and asset management. The reason is that those insurance activities that account for the bulk of assets and liabilities, namely life and savings contracts, have their origin in providing a complementary role to social security systems, which by definition vary greatly from country to country.
2. AIG was not insurance. The business that brought AIG down was a type of banking business, undertaken not by the insurance company of AIG in New York, but by a financial subsidiary located in London, called AIG Financial Products. Using the insurer’s balance sheet and top rating, the subsidiary provided credit enhancements of US subprime products, mainly to banks, by selling over $500 billion of credit default swaps, which are not an insurance product but a non-regulated financial product (Baranoff 2012).
3. Systemic risk channels for insurance have not been identified. Whereas for banking institutions the origin and propagation of systemic risk channels are well identified, both conceptually and empirically (Allen and Gale 2000, De Bandt and Hartmann 2000), this is not the case for insurance.
For banks these three steps can broadly be described as follows:
- First, the primary source of vulnerability is given by the combination of fugitive liabilities, particularly deposits, including in the interbank market, combined with stickier long-term assets as a result of maturity transformation.
- Second, their transmission to the banking system predominantly occurs through the institutional interconnectedness to other banks that are short-term, callable at will and largely based on trust.
- Third, the transmission to the real economy can occur through a combination of a fall in trust in the safety of deposits and disruptions to the payment system and/or the provision of credit.
For insurers, none of the bank-specific channels apply. Liabilities represent no means of payment, are less fugitive and mostly longer-term, assets are broadly matched and there is no ‘inter-insurance market’ as there is an interbank market with direct balance sheet exposure across institutions. The sole potential channel of transmission lies in the role of financial intermediary and investor. The issue of transmission channels of insurance-originated systemic risk is still open.
4. The systemic interconnection of insurers is not yet well identified and is certainly different from banks. There are four essential distinctions with regard to the systemic interaction between banks and insurers (Thimann 2014b):
- Banks are institutionally interconnected. They establish the ‘banking system’ – a structure of directly interrelated parts. Insurers are not institutionally interconnected; they are stand-alone operators. No ‘insurance system’ and no ‘central insurer’ comparable to a central bank exist.
- Banks engage in maturity transformation combined with leverage; they transform short-term liabilities into longer-term assets. Insurers pursue a liability-driven investment approach, trying to match their asset profile with their liability profile, and they can generally hold assets to maturity.
- Liquidity risk is inherent in banking, but not in insurance. Banks risk being liquidity-short; insurers are liquidity-rich. In contrast with bank deposits, the liabilities for insurance of general protection, property, casualty, and health are not callable at will. They relate to exogenous events that policyholders do not influence and that are not correlated with financial market cycles.
- Banks deal with the payment function, they create credit, and their liabilities constitute money. If the function of money, credit, and payments is impaired, immediate consequences for the economy arise. Insurers do not create credit, and their liabilities do not constitute money but an illiquid financial claim.
5. Leverage – a key concern for systemic risk – is inherent in banking (Ingves 2014) and quasi-absent in insurance. Leverage is the key challenge for addressing systemic risk because it creates boom-and-bust debt cycles. Insurers do issue and hold debt, but they do not do so to purchase financial assets to make leveraged returns. They do so mainly to finance mergers and acquisitions, and to a lesser extent, to establish a cash buffer if needed or to buy fixed assets (buildings etc.).
6. Insurers have larger loss absorption capacities than banks in case of crisis. For banks, the loss absorbency on the liability side is mostly confined to the equity tranche. In insurance, the bail-in is built in – there is an inherent loss absorption capacity in the form of beneficiary participation, which constitutes a significant part of life insurance contracts.
7. The linchpin of bank systemic regulation is capital. For banks, higher capital requirements are effective in addressing systemic risk because, in addition to controlling leverage, they raise the costs of balance sheet growth and augment the immediate loss absorption capacity of individual institutions. In insurance, capital has a very different role – it serves essentially to ensure that the last policyholder is being paid (Plantin and Rochet 2007).
This difference has an important implication for systemic regulation because it changes the effectiveness of capital surcharges. Raising capital for insurers essentially means that there are (even) more assets available to cover the liability stream than otherwise, but such additional capital will be consumed, if at all, at the end of the process of distress and possible resolution, and has no crisis prevention or stabilisation function.
8. Europe and the US – the world’s two largest insurance markets – have different accounting standards. Whereas Europe adopted the International Financial Reporting Standards, the US follows its national Generally Accepted Accounting Principles standard.
9. Europe and the US maintain fundamentally different regulatory standards. Europe is about to finalize the world’s most advanced, ambitious and complex regulatory standard with Solvency II. It aims to capture an economic concept of risk, provides market-consistent valuations, and is essentially based on mark-to-market accounting. In contrast, the US maintains its longstanding risk-based capital standard, and national regulators explicitly exclude replacing the US capital framework with any international standard (NAIC 2013).
10. There are fundamentally different supervisory standards between Europe and the US – and even within the US, as insurance is supervised at state level. Moving from sub-national supervision to supra-national capital standards would be a considerable jump.
There is no doubt that insurers are an important component of the financial sector and that large insurance companies are both significant financial intermediaries and important investors in financial markets. There is also no doubt that they play an essential economic role, by allowing firms and households to manage economic risk. In that sense, insurers are systemically important for the economy because they provide an essential economic function.
What is less evident, and what needs further study, is the extent to which insurers can be originators or transmitters of systemic risk in the financial system – the risk that causes large parts of the system to fail. This question warrants more research into the sources and transmission channels of risk. Such research should be rooted in the business model and balance sheet structures of insurance companies, which clearly differ from those of banks.
Advancing the regulation of ‘systemic risk’ in insurance without such an explicit understanding of sources and transmission channels could end up missing the point – it might not address the right aspects and it might not use the right tools. In particular, given the different economic and financial role of capital compared with banking, it is not evident that capital surcharges would be the preferred instruments in insurance.
Insurance regulators are fully aware of these issues. They should be given the time and the analysis to address them in the right way and in the right sequence.
Published in collaboration with VoxEU
Author: Christian Thimann is Member of AXA’s Executive Committee and Group Head of Strategy and Public Affairs. He is also affiliated Professor at the Paris School of Economics.
Image: A man walks past Japan’s Dai-ichi Life Insurance company headquarters building in Tokyo April 21, 2011. REUTERS/Yuriko Nakao