22 April 2013

VoxEU: Systemically important insurers

An unintended consequence of tighter banking regulation is that businesses are looking beyond banks for their loans. This column argues that this arbitrage opportunity may create systemic risks, including amongst major insurance companies.

Authors: David Veredas, Matteo Luciani, Mardi Dungey

An arbitrage opportunity is being created for insurers and, if not overseen, it may entail systemic risks. Banking disintermediation – the search of institutions to find other sources of financing than banks – is on the rise as banks come under pressure. New regulations and capital constraints in the banking industry entail the need for more liquid instruments, such as government bonds, and retrench profitable trading activities and business lines deemed to be too risky, and hence too expensive. Since the capital treatment for insurers is, so far, less onerous than for banks, insurance groups are filling the void left by banks. Insurance companies have sizeable quantities of cash from policyholders and do not face the same funding issues currently affecting many of the banks. This new group of lenders is looking for alternative venues for their liquid cash.

The traditional insurance business is not systemic...

Per se, and as John Gapper correctly points out in the Financial Times, insurance is a less threatening activity than banking for the financial system as a whole. Insurers can get the risk of having to make payouts wrong, but it is very unlikely that they will suffer something like a bank run. In the aftermath of the financial crisis, there were no significant and negative collateral effects in the insurance sector. It ran and functioned normally and the rates rose significantly only in sporadic cases as a consequence of payouts due to costly but random events, such as earthquakes and hurricanes, and not as a consequence of the financial crisis.

…but other lines of business can be

This can change, however, if they get involved in non-insurance underwritings that may make them systemically relevant. The case of AIG, prior to September 2008, engaged in credit default swaps is a good example. Currently, the vacuum left by banks could display similar characteristics, as reflected in several investment vehicles:

• First, and according to a recent study from Allen & Overy, real estate finance is one of the markets where we are seeing tangible signs of insurance credit becoming available.
• Second, there is also an increasing scope for insurance firms to compete in corporate lending. Insurers lend their excess liquidity to the banking sector in the form of liquidity swaps and other transactions. A similar scenario is collateral transformation, in which an institution trading through a central counterparty swaps – in the repo market – securities that are non-eligible as collateral for cash or short-term debt owned by, for instance, insurers.
• Third, insurance firms are stepping into the infrastructure debt market, and their lending is expected to increase substantially, according to a recent study by Standard & Poor’s.
• Last, in a survey conducted by ING on managers involved in insurance company assets, 66 per cent of respondents said that insurers will increase their equity allocations over the next five years, against only 8 per cent anticipating a cut. This increase is motivated by the search for yield, despite the high capital reserves imposed by Solvency II. The bottom line of these examples of non-insurance underwritings is that investment insurance groups are acting, and will increasingly act, as shadow banks, since they replace traditional banks as lenders.

There are many unknowns regarding shadow banking. It is difficult to track price movements, particularly in a market that is relatively illiquid. This poses the threat of a build-up of systemic risks because of the opaque nature of the sector. And some of the aforementioned lending activities, looking back, have shown themselves to be too risky and expensive for the taxpayer. Take real estate lending - the legacy of the last property bubble continues to weigh heavily on the banking sector as provisions against bad loans ate into profits and, in many cases, have required bailouts.

The International Association of Insurance Supervisors is about to announce its plans to deal with systemically important insurers and the Financial Stability Board will announce a list of such insurers – in the same spirit as it did with globally systemic banks – by the middle of this year. The criteria for joining the list will focus on the importance of their non-insurance underwritings, their centrality to the financial system, and their size. The metric to produce such a list is, however, still unclear...

Conclusions

Probably the most fundamental regulatory concern today is the supervision of systemically important financial institutions. While much of the debate in the aftermath of the financial crisis focused on banks, insurers are also financial institutions that because of their size, market importance, related non-insurance businesses, and their sheer connectedness, may well be systemic. The Financial Stability Board is right in caring about insurers - the authors' results show that they are becoming systemic.

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