The IAIS, with its proposal for additional risk-adjusted capital rules for major re/insurers, seems to be joining the regulatory bandwagon for seeing these as a potential source of threat to to the global financial system.
However, other than when they choose to act as ‘shadow banks’, the exact basis for why even the largest re/insurers should be considered to represent a systemic source of risk is debateable to say the least, particularly if that leads to a requirement for additional capital levels over and above those already considered prudent within existing and proposed insurance regulatory regimes such as Solvency II. Extra capital can mean only one of two things; less re/insurance or more expensive re/insurance.
The concept makes little sense in general, and particularly so for reinsurers.
Systemic risk derives from the ‘contagion’ (domino) effect when the failure of one organisation triggers that of others. This may be caused either by the consequences of ‘fear’ – leading to creditors demanding their money back and asset prices plunging; or by the knock on impact of bad-debts on the failed organisation’s creditors.
The former is the classical ‘run on a bank’ problem.
But there is no routine concept of a ‘run’ on an insurer. Some savings or investment related life insurance products can contain an option for policyholders to demand an immediate pay-out; but that ‘liquidity and ALM’ risk would be specific to the insurer. A systemic problem would only result if a significant number of life insurers had this as a major exposure and policyholders lost confidence in them collectively. Even that is a lot more manageable than controlling the nature and consequences of a banking crisis.
The ‘bad debt’ (unrecoverable reinsurance) problem would be the impact of the failure of a major reinsurer. Theoretically in extremis this could cause a systemic problem within the industry but the nature and scale of the failure would need to be so profound as to really be outside of the scope of capital rules (given the reinsurer would not only need to go bust but be capable of paying so little of any given claim that the loss to other re/insurers from unrecoverable reinsurance is sufficient to create further failures).
A more probable (though hopefully still extraordinarily remote!) risk would simply be the systemic nature of a huge catastrophic event wiping out much of the reinsurance industry in one fell swoop. But, again, that is a risk that really falls outside any reasonable application of regulatory capital rules.
A sounder prudential regulatory approach might be to simply prevent regular re/insurers trading credit protection products (shadow banking).
Better still would be thinking again about whether a ‘mark to market’ approach to valuing re/insurers’ invested assets (the near universal direction of travel in accounting and regulation) really adds stability to the system; restricting, as it does, the ability of these otherwise natural ‘buy and hold’ investors to provide a rationale ‘pricing floor’ in traded financial assets during a crisis (which is when it actually matters) this could simply make things a great deal worse (to wit preventing those financially capable of ‘catching the falling knife’ from actually doing so).
Indeed, were that to be addressed then, far from being a source of systemic risk, re/insurers could be a source of systemic risk mitigation.
Stuart Shipperlee, Analytical MD, Litmus Analysis