The International Association of Insurance Supervisors (IAIS) has published a paper today which provides their perspective on the role of the re/insurance industry and its interaction with the wider financial markets. The report suggests that the more re/insurers get involved in non-traditional techniques of risk transfer the more likely they are to pose global systemic risks through the links between these transactions and the financial markets and institutions.
Examples of non-traditional activities that re/insurers participate in which could make them more vulnerable to financial market developments and thus more likely to contribute to systemic risk include credit default swaps (CDS) transactions for non-hedging purposes or leveraging assets to enhance investment returns and other transactions which blur the lines between traditional insurance, reinsurance and investment bank type activities. This, of course, includes insurance-linked securities and catastrophe bonds as well as underwriting techniques such as financial guarantee insurance and finite insurance.
Peter Braumüller, Chairman of the IAIS Financial Stability Committee, commented; “Based on information analysed to date, for most lines of business there is little evidence that traditional insurance generates or amplifies systemic risk within the financial system or the real economy. However, supervisors need to monitor very closely those insurance activities that deviate from the traditional insurance business model.” He added; “The differences in the impact of failures of insurers and banks should be reflected in the measures applied.”
The graphic below, taken from the IAIS report, is particularly interesting as it shows an example of some activities which could be undertaken by an insurance or reinsurance group and their relative degree of financial interconnectedness. The items with higher financial interconnectedness pose greater systemic risk, says the report.
They stress that this is illustrative, but to anyone with an understanding of these tools and instruments the position on the axis makes sense.
On insurance-linked securities, the report mentions the issue of total-return swaps and how that can potentially expose both sides of the deal to financial interconnectedness. They mention the example of Lehman Brothers and also that since then the approach to collateralisation has materially changed. In fact that has changed so much that total-return swaps are rarely, if ever used in cat bond transactions any more.
The report notes that given the small size of the insurance-linked securities market, when compared to other activities within the insurance sector, that in general it does not generate additional underlying risks. The report states:
ILS markets serve as distribution mechanism for parts of insurance risks for which (re)insurers remain ultimately liable. (Re)insurers continue to have “skin in the game.” This adds a risk governance component, which limits the potential for systemic risk. Of course, risk securitisation based on poor underwriting and inadequate risk management may potentially create systemic issues similar to the ones observed with the securitisation of sub-prime loans prior to 2007. That is why supervisors will continue to monitor the growth of the ILS market (which up until now has been very small) and the standards adhered to by the issuing entities.
This all amounts to a great deal of common sense in our opinion. The fact that risk is being sold to capital market investors as securities suggests a greater level of financial interconnectedness than traditional underwriting methods and as such it deserves a greater level of financial oversight. There is nothing for the market to be concerned about in this report, however, should the ILS and cat bond market grow significantly we’d expect there to be increasing scrutiny on the parties involved in transactions to ensure interconnectedness is dealt with in a prudent manner.
You can download the full paper from the IAIS titled ‘Insurance and Financial Stability‘ in PDF format.