Insurance. They very name sounds reassuring, conjuring up images of stability and security. Inside the apparently dull industry, however, there is vigorous debate about risk and regulation, systematic importance and capital requirements, a debate that will be key to determining the future shape of the industry.
In the wake of the financial crisis, regulators’ attention has been focused on banks, where there has been regulatory change in everything from capital requirements to governance. Insurers, by contrast, have attracted less attention.
The industry itself has undergone significant change over the last 20 years and risks are no longer confined to the traditional trio of interest rates, aggregate longevity and changes in policy holder behaviour, which companies are accustomed to managing. Factors such as the use of captive insurers, the growth in policies with guaranteed returns and the use of derivatives and hedging techniques have altered the industry’s risk profile and stimulated regulatory debate.
There has also been considerable debate over the extent to which the insurance industry represents a systemic risk. While the discussion continues, the Financial Stability Board has identified nine global systemically important insurers (G-SIIs), including US companies Met Life and Prudential Inc, Aviva and Prudential in the UK, Ping An in China and Axa in France. The International Association of Insurance Supervisors (IAIS) has now outlined higher capital requirements for this group, reflecting their greater importance to global financial stability.
The regulatory, economic and systemic risk of the insurance industry was the subject of a conference at London Business School, with contributions from industry executives, global regulators and academics. A survey is in progress as part of that debate and highlights the industry’s awareness of its increasing systemic risk and the need to upgrade its risk control mechanisms.
The conference will be followed by a book, co-edited by Ralph Koijen professor of finance at LBS and with contributions from all three areas, to be published in spring 2016. The aim, says Koijen, is to stimulate debate among academics, regulators, and the insurance industry about the industry’s activities, regulatory regime and risks.
Koijen identifies two key categories of risk: insurers have started selling a new range of products that offer guaranteed returns; and the industry has developed new tools to help them manage their capital more efficiently, including the use of derivatives, securities lending and the creation of captive companies. While the data for these issues comes largely from the US, because of the greater availability of information there, they are common to insurers across the world. While there are risks arising from securities lending and derivatives, Koijen identifies shadow insurance, through captives, and guaranteed products as the key areas for concern.
Why are shadows growing?
One of the most significant areas of increased risk was a by-product of regulatory changes: in 2000 and 2003, a new regulatory regime in the US, commonly refer red to as Regulation XXX/AXXX, required higher reserves against term and whole life insurance policies. This meant that companies were able to write fewer policies for a fixed amount of capital. These regulations did not, however, apply to reinsurers. Reinsurance has traditionally been used as a way of sharing risk across the industry and reinsurance companies are governed by a different set of accounting principles and need lower amounts of capital against their business. Companies affected by the new regime started moving policies to reinsurers, initially using unaffiliated, third party companies but then moving to establish their own captive, or shadow, reinsurers, encouraged by laws introduced in 26 US states allowing shadow companies.