Insurers pose limited systemic risk as long as they stay on their traditional path
Worldwide, insurers have emerged relatively unharmed from the credit crisis. Yet, there is a call to take more control of systemic risks and to reduce them. According to Professor Roger Laeven, this is especially relevant in the case of insurers whose activities extend beyond the traditional boundaries of the insurance business.
The number of insurance companies worldwide that needed capital support from the government during the credit crisis of 2008 was very small compared to the number of banks that needed to be rescued. The macroprudential requirements that have been imposed on the financial sector since 2008 have therefore mainly resulted in mandatory measures for banks. So large, systemically relevant banks are now required to hold more capital and banks are expected to build up additional buffers in times of economic prosperity.
Yet, policy makers, supervisors and scientists are facing a difficult question: to what extent are insurers system relevant and what consequences might this have for supervision? According to Roger Laeven, Professor of Risk and Insurance at the University of Amsterdam (UvA), ‘only a little macroprudential supervision is needed with respect to those insurers who concentrate on traditional activities like life insurance and general insurances protecting against damage and loss of assets. Laeven is of the opinion that banks and insurers are often lumped together, by the media for example. ‘This is incorrect, because banks are exposed to other kinds of risk, and they also generate other kinds of risk than insurers do. The crisis clearly demonstrated this.’
Laeven defines systemic risk as the phenomenon where an event in a specific financial institution has a high probability of repercussions for the financial sector as a whole, and possibly for the real economy. To define whether a financial institution can generate systemic risks, Laeven uses five characteristics: the size of an institution, the interconnectedness with other financial institutions, the replaceability of an institution, the rate of leverage and the financial structure of an institution.
‘Banks often score poorly on these characteristics’, Laeven says. ‘There are a lot of large banks, they are interconnected with other financials, it is not always possible to replace them, they have a high leverage and banks are characterised by short-term funding.’ The latter point means that finance providers can withdraw their funds on short notice, throwing the bank into liquidity problems.
According to Laeven insurers are doing much better with regarding to systemic risks. ‘By all accounts, insurers who run traditional insurance operations are doing all right with regard to these five characteristics. In the banking sector, the amount of loan capital is often ten times higher than the amount of equity capital, but in some cases ratios of twenty or more occur. This ratio is around or just below ten for life insurance companies and just two or three for general insurance. Indeed, the financial structure of insurers consists predominantly of long-term liabilities, with payments due far in the future.
Things are different for insurers who conduct other activities than the traditional life or general insurance, or who invest their premiums too heavily in high-risk assets. Laeven: ‘The best example is the American insurance company AIG, which needed a bail-out in 2008. AIG had specialised in selling complex derivatives, such as credit default swaps, used by the buying parties to hedge their credit risk. AIG was, so to say, turning into a bank.’
According to Laeven macroprudential supervision of these kind of insurers is an absolute necessity. ‘The practice of selling huge amounts of derivatives has diminished by now. Although a lot of insurers still choose to invest in complex assets.’ As an example, Laeven names the so-called Mortgage Backed Securities (MBS). At the origin of these securities are property loans sold by banks, which are subsequently sold in all kind of packages, each with their own risk characteristics. ‘Pricing this kind of products is difficult, and they are not transparent. It are these kind of products that create a risk and that played an important role in the credit crisis, because they strengthen the interconnection between financials and weaken the financial structure, two of the characteristics of systemic risk mentioned earlier.’
One of the problems is how to define when an insurance company diverges from the traditional path. Laeven says, ‘We are not fully aware to what extent insurers create alternative products, or to what extent they invest in these products. The reasons for this are, among other things, that insurers work with subsidiaries in different jurisdictions, that detailed quantitative information is not easy available and that the methodology for determining systemic risks by the international supervisor is under discussion. This needs to be improved.’ Laeven thinks that more effective requirements regarding information, group supervision, resolution schemes and capital for certain insurers with non-traditional activities will be put in place once the supervisor will have developed a better methodology.
When it comes to traditional insurers, Laeven thinks that limited scope macroprudential requirements will be sufficient, provided they keep away from investing in complex assets. ‘The current supervisory framework Solvency 2 hardly imposes any macroprudential measures, and in fact they are not necessary for traditional activities.’
Laeven, who is also visiting professor at Princeton University, and a colleague from this university are working on a model together that better identifies systemic risk. The model can be used for all financial sectors and Laeven is convinced it will help to better predict the aftermath of a crisis.
The results from what are referred to as backtests are positive. ‘In our model we can much better incorporate risks such as the interconnectedness between financial institutions than in the models used by supervisors, financials or financial traders.’ According to Leaven, progress has especially been made with respect to the ‘anatomy of patterns’ of data.
However, even with this model Laeven will not be able to predict the occurrence of crises. ‘We may have become much better at predicting the aftermath of a crisis, but it would be an illusion to think that we can foresee the first shock, just as that is also not possible with regard to earthquakes. In that sense, crises will always continue to occur.’
More information? Email: R.J.A.Laeven@uva.nl