Finally We Are on the Right Path to Addressing Potential Systemic Risk in Insurance
February 16, 2018 by Thomas Leonardi
Policymakers in the U.S. and around the world are re-thinking the approach to assessing and addressing potential systemic risk in the insurance sector. It’s an important evolution and offers insight into both how we got here and where we’re now headed.
Ultimately, I think we’re finally on a more constructive path.
Following the financial crisis, many of the regulatory tools developed to address systemic risk were simply imported from the banking sector. Although many regulators and policymakers, including me during the four years I served as the sole U.S. regulator on the IAIS’s Financial Stability Committee (FSC), acknowledged that the banking business model was quite different. Early proposals to address potential issues in the insurance industry were not sufficiently tailored to our industry.
A key import that both the FSC and the Financial Stability Oversight Council (FSOC) in the U.S. (under the Dodd-Frank Act) borrowed from the banking sector was an entity-based approach (EBA) wherein a handful of large entities deemed to pose systemic threats to the financial system were designated as ‘SIFIs’ (systemically important financial institutions). Those companies designated as SIFIs would then be subjected to greater prudential oversight, higher capital levels, and would be required to produce recovery and resolution plans.
While the EBA and other reforms of the last ten years have made banking and the financial system as a whole much safer, this is a flawed approach when it comes to insurance. In particular, it does not sufficiently acknowledge that unlike banks, which by the very nature of their business model regularly engage in liquidity and maturity transformation, insurers do not pose the same risks to the broader financial system and economy.
It’s actually quite the opposite. Insurers are not highly interconnected with other financial companies in the financial system such that one failure would likely trigger another. We don’t supply the indispensable flow of cash and credit in the economy – we’re typically customers, not providers, of financial intermediation services. Insurance companies also avoid many other risks that banks pose. Take life insurers – their liability-driven investment approach matches assets to liabilities, which are long-duration and illiquid. For providers of natural catastrophe policies, risk exposures are uncorrelated with market risks (flood waters don’t rise because interest rates do) and this diversification of risk is a stabilizing factor. Furthermore, insurers benefit from a regular stream of premium income, which boosts liquidity.
In addition, there are significant technical flaws in how the EBA has been implemented. One problem is that it is an overly formulaic approach. For instance, insurers are penalized for holding illiquid assets, regardless of whether the asset is held to maturity and matched by a corresponding illiquid liability. In addition, the EBA’s focus on a handful of large insurance groups can distort competition and misdirect supervisory resources away from a broader sector-wide assessment of potentially systemic activities.
Attention is now shifting to a better approach for addressing potential systemic risk outside of banking. In 2016, rather than designate certain large asset management firms as systemically important, U.S. and international regulators focused on specific activities conducted by many companies that potentially pose systemic risk.
This “activities-based approach” to systemic risk (ABA) was endorsed again last October, when the U.S. Treasury Department released a report on the asset management and insurance regulatory frameworks calling for an ABA to address systemic risk in both sectors. Importantly, in the U.S., the Dodd-Frank Act already allows for an ABA without the need for new legislation. This U.S. re-think parallels global standard-setting efforts for non-banks as the IAIS has been working to develop an ABA framework.
I have three reasons to be optimistic about this re-think. First, it is occurring as most major jurisdictions around the world have made significant improvements to the way they regulate insurance groups. Second, I see strong potential for a right-sized approach to addressing systemic risk in insurance through an ABA. Third, the apparent alignment in local and international policymaking efforts provides the insurance regulatory community with an important opportunity to coalesce around a single, workable framework for addressing systemic risk.
Let me take each of these points in turn.
Insurance regulation in major jurisdictions – which was already well-established and tested – has been further enhanced in recent years to reflect the lessons of the financial crisis. We need to be mindful of these significant improvements in prudential regulation as a key factor in reducing potential causes of systemic risk. Many commentators look to enhanced capital buffers as a be-all and end-all in combating systemic risk. But it’s not all about capital. If there had been a 3% capital surcharge applied to AIG in early 2008, it would have done nothing to prevent its liquidity crisis. But enhanced and effective prudential regulation might very well have done so.
In the U.S., the Solvency Modernization Initiative established significant revisions to the Model Insurance Holding Company System Regulatory Act, giving U.S. regulators the power to access information on all aspects of a large international insurance group (including non-insurance and non–finanical entities operating within the group). It also enacted the use of Supervisory Colleges, ORSAs, Enterprise Risk Reports and enhanced corporate governance requirements. In addition, the NAIC is working on its Macro-prudential Initiative that takes into consideration stress testing, counterparty exposure, liquidity, and resolution plans. These are valuable tools that bolster the U.S. State regulators’ ability to supervise large cross-border insurance groups and also provide a better shared understanding about group risks among supervisors from other jurisdictions.
I see promise in an ABA for a variety of reasons. An ABA will enable a policy framework for addressing potential systemic risk that is appropriate to insurance and proportionate to the need.
A focus on certain activities rather than on a handful of large insurers will facilitate an effective and tailored approach to systemic risk management.
By focusing on targeted activities, regulators will be able to hone in on select systemic risk transmission channels and adapt to new and evolving potential risks.
A properly designed ABA will also complement local regulatory initiatives and promote alignment between local and international efforts. For example, the NAIC’s Macro-prudential Initiative, noted above, is a promising example of the type of policy construct that would make an ABA credible and effective. We think that the NAIC has focused on the most effective policy measures, in particular the importance of assessing liquidity under stress conditions. Considerable work lies ahead, including refining the scope of an ABA and designing an appropriate set of policy measures, but we are on the right track.
These developments emphasize the unique opportunity not only to improve the way systemic risk is addressed in insurance but also to ensure a cohesive framework. Defining the proper scope and function of an ABA will take time. But if we seize this opportunity, I am confident that the insurance sector is on the cusp of an important evolution in our thinking about systemic risk.
