New Swiss Re sigma study warns against a regulatory over-reaction

Zurich, 13 September 2010 � While the insurance industry weathered the financial crisis relatively well, acting as a source of stability in the global financial system, the turmoil exposed flaws in the way insurers are regulated. Swiss Re’s latest sigma study “Regulatory issues in insurance” finds that improvements could be made to the regulatory environment for insurers, but warns against a potentially damaging over-reaction to the crisis. When considering reforms, particular attention should be paid to the supervision of insurance groups, managing liquidity risk and the pro-cyclicality of capital risk charges, the report suggests.

During the financial crisis, the insurance industry continued to operate as usual and insurance regulations were reasonably adequate. With very few exceptions, insurers did not need government support. Nevertheless, substantial changes to the regulatory environment are being considered, which could create distortions in the market that ultimately harm policyholders as well as the economy.

Insurance and banking require different regulatory approaches

Regulatory reform has mainly targeted the banking sector, but some regulations are being extended to the insurance industry in the interest of perceived consistency. Dr. Kurt Karl, Swiss Re’s Chief US Economist and one of the authors of the new sigma study, said: “The business model of insurers is fundamentally different from that of banks because their liabilities are not payable on demand, since they generally require an insured event. Also, insurers can fail without threatening the stability of the financial system, since they are not as interconnected as banks and because their liabilities can be run off over an extended period of time.”

A major concern stemming from possible regulatory changes is that overly stringent capital requirements could force insurers to make investment decisions that are too conservative, which could lower olicyholder returns. Karl added, “From a macroeconomic point of view, such an investment shift would not be desirable for the economy as a whole as it lowers the amount of capital to finance growth.”

Effective group supervision is needed

Although insurers fared well during the crisis, the severe problems at a few bank/insurance groups revealed the importance of effective group supervision. The problems invariably stemmed from their banking operations, but affected the entire group.

When the banking operations got the groups into trouble, they were dissolved or required government assistance. Astrid Frey, one of the authors of the study, said: �While the insurance carriers of these groups suffered from the crisis, they remained sufficiently capitalised. Still, this crisis raised awareness that the supervision of insurance groups, particularly those operating across borders, is necessary to understand the overall risk profile of the company.” The International Association of Insurance Supervisors (IAIS) has recently started an initiative to make group-wide supervision of internationally active insurance groups more robust and effective.

The importance of managing liquidity risk

During the crisis, liquidity risk, which is not a major problem for insurers, became an issue for some companies as they were forced to obtain sufficient liquidity to meet short-term obligations. Some life insurers had increased their liquidity exposure by lending out an excessive amount of their assets through securities lending programmes without appropriate over-sight, and investing part of the collateral in assets that became illiquid during the crisis. Ratings downgrades of assets or of the (re)insurers themselves also increased liquidity needs. Karl noted, “(Re)insurers need to regularly monitor such potential liquidity requirements based on severe stress scenarios. These scenarios should include a situation where parts of the capital markets become temporarily illiquid, and may need to include a scenario that combines market stress and a catastrophic insured event.”

The pro-cyclicality of capital risk charges is a challenge

The crisis also highlighted some pro-cyclical elements in regulatory requirements that are based on market values. When asset prices fall, a downward spiral can occur as some companies may need to sell their riskiest assets to preserve adequate capitalisation. This could trigger further price declines, forcing companies to de-risk their investment portfolios further. Frey pointed out, “This is an undesired outcome of some solvency frameworks and should be mitigated when possible. Authorities are working on mechanisms that reduce capital requirements during periods of severe market stress. “

Economic and risk-based regulatory frameworks support insurance efficiency and growth

Oversight of the insurance industry is necessary to protect policyholders. Modern regulatory and supervisory regimes such as Solvency II or the Swiss Solvency Test take an economic view and are risk-based. Karl stated, “If implemented properly, such regulations will create an environment in which the insurance industry can operate efficiently and promote financial stability and economic growth.”

Table 1: Differences between banks and insurers
Issue Insurers Banks
Liquidity risk Insurers have mostly liquid assets and illiquid liabilities. Insurance liabilities are generally triggered by an insured event. However, life savings products can be redeemed, but usually only at a high cost. Insurers have very little short-term funding and aim to match the duration of their liabilities and their assets. Many of the liabilities of banks � deposits, saving accounts and commercial paper � are short term, ie they can be withdrawn at short notice. Many of a bank’s assets, eg loans, are long term and illiquid. This liquidity and duration mismatch makes banks vulnerable to bank runs.
Contagion risk Insurers do not lend to each other, making them less vulnerable to contagion. The large size of the interbank market makes banks vulnerable to contagion.
Unwinding process Due to the long duration of liabilities, insurance books of business can be liquidated by regulatory authorities in an orderly manner over the life of the liabilities. Due to the risk of a bank run, regulatory authorities must often act very quickly to take over a bank to avoid any further disruption to the banking system and the economy.

Source: Swiss Re Economic Research & Consulting

An additional publication focusing on systemic risk and insurance and entitled “Striking the right balance: Insurance and systemic risk regulation” is available to download on Swiss Re�s website

About Swiss Reinsurance Company Ltd

Swiss Re is a leading and highly diversified global reinsurer. The company operates through offices in more than 20 countries. Founded in Zurich, Switzerland, in 1863, Swiss Re offers financial services products that enable risk-taking essential to enterprise and progress. The company’s traditional reinsurance products and related services for property and casualty, as well as the life and health business are complemented by insurance-based corporate finance solutions and supplementary services for comprehensive risk management. Swiss Re is rated “A+” by Standard & Poor’s, “A1” by Moody’s and “A” by A.M. Best.