As insurance-linked securities markets grow potential for systemic risk needs to be monitored

The International Association of Insurance Supervisors (IAIS) have published a follow up to their November 2011 paper on the insurance and reinsurance sectors and whether they contribute to global systemic risk. The latest paper looks specifically at reinsurance and concerns related to whether there are connections between reinsurance and broader financial stability. It looks at market concentration rates, accumulation and high value risks, similarities of reinsurance portfolios and alternative risk transfer or non-traditional reinsurance activities.

You may remember that the IAIS also published a paper proposing a methodology for identifying globally systemically important insurers and reinsurers in May of this year (our article on that proposal can be found here) and this latest paper forms part of a series of attempts to identify any systemic linkages and risks within the sector.

On traditional reinsurance activities the IAIS concludes that it is unlikely to cause, contribute to or amplify systemic risk. While business relationships are confined to traditional reinsurance activities, any intra-sector connectivity is unlikely to spill over into the broader financial markets. They see the insurance and reinsurance market as a hierarchical structure which dampens the propagation of shocks through the market, meaning that shocks are unlikely to be amplified to a systemic proportion. These findings also apply to the bulk of non-traditional reinsurance activities and alternative risk transfer activities. while ART and some non-traditional instruments comprise financial market characteristics such as derivatives, in most cases they do not intermediate credit. Consequently, the IAIS says, the failure of reinsurers involved in most non-traditional or ART activities will not undermine a larger credit pyramid or lead to systemic risk.

However, the IAIS do note that there is the potential for some of the non-traditional markets to lead to a level of systemic risk between reinsurance and the broader financial market, particularly if their use grows significantly. They cite insurance-linked securities and catastrophe bonds as an example of a sector which while a small portion of the overall reinsurance market as it is today poses little risk, if it grows significantly there could be a systemic risk worth monitoring. Hence they conclude that these kind of risk transfer activities do need to be monitored to ensure it does not become overly risky.

The convergence of reinsurance and investment banking, which comprises the arena that Artemis covers to a large degree, is the area of the reinsurance market which poses the most potential to become a systemic risk in the future. They break this area down into non-traditional reinsurance (alternative risk transfer, insurance-linked securities etc) and non-insurance activities (project finance and investment banking) and these are where the greatest potential for a systemic risk can be found.

On non-insurance activities, such as CDO’s, CDS’s and similar instruments, the IAIS says that the experience of the financial crisis suggests that reinsurers and insurers engaged in these activities are likely to become originators and amplifiers of systemic crises. As a result they say that supervisors need to monitor both innovation and changes in insurance business models, and be prepared to broaden the regulatory perimeter to include particularly these non-insurance activities that could have potentially adverse consequences for reinsurers, insurers and the wider financial system.

On the non-traditional convergence market, which includes ILS and catastrophe bonds, the IAIS says that if this existed at a larger scale re/insurers engaging in convergent activities would indeed be a linchpin to the wider financial markets, potentially amplifying, and contributing to systemic financial risk. However there is no real record to prove this assumption to date. The ILS and cat bond market, where the IAIS says convergence has gone the farthest, remains small when compared to the total reinsurance market size. They note it is tiny when compared to the universe of asset backed securities (ABS). They consider this an important factor when looking at how these activities impact systemic risk arising from reinsurers compared to entities such as banks.

On industry-loss warranties, the IAIS say that the increasing customisation of the instruments means that from a supervisory perspective attention should be paid to the management and measurement of basis and credit risks in ILW’s. They note that single trigger ILW’s are more akin to financial derivatives, no collateralisation and no insurable interest, and as such this suggests the need for close monitoring of market growth. Interestingly they also suggest that supervisors may want to foster an appropriate collateralisation of ILW’s.

The report also notes that we do not seem to see the retrocession spirals such as the one the Lloyd’s market experienced in the 1980’s anymore. They put this down to improved oversight and supervision and an improved ability of the reinsurance market to absorb large losses, such as those experienced in 2011 which triggered retro contracts but with no adverse affects emerging. Of course the market is very different now, with capital coming from different sources so it is hard to compare. However the IAIS have run extreme stress tests which they say large reinsurance groups have survived and as such they have a lot of confidence in the sector.

Back to ILS, and the IAIS says it’s crucial to differentiate between life and non-life ILS when looking at the potential for systemic risk. In the non-life sector (so cat bonds) there is a transfer of peak risks to the capital market with minimal financial market (ie. interest rate) risk, where as life ILS deals may entail a considerable degree of equity market, interest rate and credit risks. So perhaps the life sector could become considered a systemic risk first where both life and non-life ILS markets to grow considerably in size.

The IAIS also notes that the non-correlated (or uncorrelated) nature of cat bonds and ILS must be carefully watched, as during times of financial crisis they are likely to show higher correlations with other financial market instruments and investments. They cite the 2007-2009 period when cat bond returns were more closely correlated with other indices for a time. However, a lot of that correlation occurred due to the Lehman default and being a young market it’s hard to prove correlation either way yet, but it is something that must be watched.

The IAIS concludes on ILS and cat bonds:

At this time, it is difficult to see how the marginal ILS market could give raise to systemic concerns, but going forward its growth and potential for systemic ramifications need to be monitored carefully.

That seems an eminently sensible approach to take with any financial market instruments and we don’t believe this monitoring would have any negative impact on the sector. In fact, the monitoring and supervision of ILS and cat bond market participants to ensure there is no risk of systemic interconnectedness emerging as the market grows can only be a good thing for participants and encouraging for investors in the sector.

The IAIS suggests that to prove whether cat bonds, ILS, ILW’s and other non-traditional reinsurance instruments are systemically risky they must be assessed on empirical grounds to find the answer. They refer back to their work on developing a methodology for this and hope that it will enable them to provide an answer.

The IAIS report makes for interesting reading and contains a lot more than we’ve covered here on other areas of reinsurance. You can access a copy in PDF format here.