When assessing systemic risk, focus on activities of systemic importance: Geneva Association

The Geneva Association, a leading international insurance think tank for strategically important insurance and risk management issues, has offered its opinion to the International Association of Insurance Supervisors (IAIS) on their work to identify globally systemic insurers and insurance activities. The IAIS have proposed a methodology to identify systemic riskiness in the insurance and reinsurance market, including non-traditional and alternative risk transfer activities such as insurance-linked securities and catastrophe bonds.

We first wrote about the move by the IAIS in an article titled ‘IAIS to identify globally systemically important insurers, ILS are a factor’, we followed that up with another piece ‘As insurance-linked securities markets grow potential for systemic risk needs to be monitored’. The IAIS conclude that insurance-linked securities and catastrophe bonds are an example of a sector which while a small market as it is today poses little risk, but if it grows significantly they could present a systemic risk worth monitoring. Hence they conclude that these kind of risk transfer activities do need to be monitored to ensure they do not become overly risky.

The Geneva Association has expressed some concern about the way the IAIS intend to identify systemically risky insurance activities. In a detailed submission to the IAIS they have called on supervisors to revise and improve the methodology to make it more appropriate for the insurance industry.

“The Geneva Association and the wider insurance industry have been supporting the ongoing regulatory initiatives set in motion by the G-20 to increase the resilience of the global financial system,” commented Dr Nikolaus von Bomhard, Chairman of The Geneva Association and Chairman of the Board of Management, Munich Re, “We believe that the development and promotion of effective supervisory and regulatory policies to reduce systemic risk and address information gaps is for the benefit of all concerned, including the insurance sector.”

John H. Fitzpatrick, Secretary General of The Geneva Association said, “The Geneva Association is committed to making a positive contribution to the development of effective and appropriate systemic risk regulation for the insurance industry. While the original philosophy behind the methodology as expressed in the IAIS’s November 2011 paper is sound, our submission highlights the areas where the outcome of the current methodology can be adjusted and improved. The system needs to make the best possible use of regulatory capacity by focusing on activities that can create systemic risks and not using that capacity on areas that do not.”

“The insurance business is based on the law of large numbers, that as the number of risks in a portfolio increases, the riskiness of the portfolio decreases,” continued Fitzpatrick. “Also, as the lines of business and geographies increase, it diversifies further, reducing the risk of the overall portfolio. Several of the indicators penalise this natural risk reduction rather than reward it.”

Of particular concern is the risk that there are unintended consequences and an entity is identified as systemically risky when it actually isn’t. The Geneva Association says ‘For example, the current inclusion of traditional insurance activities in “large exposures” means that the considerable holdings of government bonds and bank-issued securities owned by insurers would be subject to this indicator. In order to manage their systemic risk ranking, insurers may seek to adjust their holdings in these important assets, making it harder for banks and governments to re-finance.’

Ideally the Geneva Association would like all traditional insurance activities to be excluded from the indicators in the IAIS methodology as they say traditional insurance activities are not systemically risky. They say that size and reach of insurance entities is important, although cannot be taken as an indicator of systemic risk alone and that some non-traditional activities deserve scrutiny as well.

On non-traditional insurance activities, which include alternative risk transfer, ILS and cat bonds, the Geneva Association suggests splitting these into semi-traditional and non-traditional as some are clearly riskier than others from a systemic point of view. They say it is also important to explain why a non-traditional activity is systemically risky, something that the IAIS methodology did not make clear. Systemically irrelevant non-traditional insurance activities could therefore be excluded from the methodology, thus simplifying it. By risk-weighting non-traditional and semi-traditional activities which do pose systemic risk a scorecard type methodology could be constructed to make assessment more transparent.

On derivatives, the Geneva Association says that derivatives used for risk management reasons, ie. hedging, should be excluded from the derivatives indicator. We assume this would include derivatives such as weather derivatives or industry-loss warranties in the form of derivatives. The Geneva Association would prefer if the only derivative activities considered systemically risky where those that are truly speculative.

It’s encouraging that the Geneva Association have got involved in this discussion as it’s vital that the final methodology is balanced and does not unfairly identify any firms as systemically risky when in reality they are not.

You can read the full submission from the Geneva Association here.