29 January 2002

FSA Chief warns of Dangers in Bank-to-Insurer Risk Transfer

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Sir Howard Davies, chairman of the UK's financial services authority, has warned of the dangers of risk transfer between investment banks and insurance companies, particularly through collateralised debt obligations (CDOs).

Addressing the Association of Insurance and Risk Managers, he said there were two trends in the industry causing concern - financial reinsurance and ‘insurance-based investment banking’, where there had been rapid growth of credit risk transfers between the banking and investment banking sectors and insurers and reinsurers. Questions on reinsurance figured in two issues dominating the industry last year - the collapse of Independent Insurance and the plight of Equitable Life, the mutual life assurer.

“There are, nonetheless, some trends in the insurance industry which do cause us some anxiety” Howard Davis said. “The first is what some have come to call ‘insurance-based investment banking’. There are a number of aspects to this, some of which have been well documented by the Bank of England in their recent Financial Stability Review. We have seen a rapid growth in credit risk transfer of various forms between the banking or investment banking sectors and insurers or reinsurers. More recently these transfers have taken more exotic forms, such as collateralised debt obligations (CDOs) or indeed synthetic CDOs. One investment banker recently described synthetic CDOs to me as 'the most toxic element of the financial markets today”.

“The second source of anxiety for us arises from our analysis of the circumstances surrounding the failure of Independent, and indeed of some other companies here and elsewhere in recent years. One aspect, which was also a feature of the Equitable’s reserving arrangements, was the existence of financial reinsurance treaties, of doubtful value, with unregulated reinsurers.” On financial reinsurance, the regulator had identified instances where it is unclear whether any risk had, in fact, been transferred and where the motivation seems ‘purely presentational’. The FSA had required some companies to renegotiate their reinsurance arrangements. Sir Howard said: “I believe that a number of companies should be asking themselves some hard questions about the prudence of their reinsurance practices and, indeed - on both sides - about the business ethics of arrangements of this kind.”

See full speech of Sir Howard Davis
’Rational Expectations’ – what should the market, and policyholders, expect from insurance regulation
See also related FT articles:
City regulator warns on health of insurance industry
A toxic financial shock
Insurance industry rejects criticism by regulator

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