Methodology must acknowledge differences between traditional insurance and banking: think-tank

An insurance economics think-tank recommends revisiting proposed criteria designed to prevent destabilization of the financial system should a very large insurer collapse, including reversing the view that certain situations are detrimental.

The comments were made as part of The Geneva Association’s response to the Proposed IAIS Methodology for the Identification of Global Systemically Important Insurers, a paper released on May 31, 2012 by the International Association of Insurance Supervisors (IAIS).

The draft criteria fall into five categories: size, global activity, interconnectedness, non-traditional insurance and non-insurance activities, and substitutability.

The Geneva Association suggests the criteria do not properly acknowledge the benefit of big insurers diversifying across countries and businesses. “The insurance business is based on the law of large numbers, that as the number of risks in a portfolio increase, the riskiness of the portfolio decreases,” John Fitzpatrick, the association’s secretary general, says in a statement.

“As the lines of business and geographies increase, it diversifies further, reducing the risk of the overall portfolio. Several of the indicators penalize this natural risk reduction rather than reward it,” Fitzpatrick continues.

“The traditional insurance business model is fundamentally different to that of banks,” notes a briefing paper on the association’s submission to IAIS. “Insurers do not provide systemically relevant financial services such as the payment system or credit intermediation. These difference are not recognized in the proposed indicators however; four of the five indicator categories used in the methodology are the same as those used for banks.”

The think-tank recommends removing traditional insurance from all indicators where appropriate. “The inclusion of traditional insurance activities in the methodology is likely to detract from an effective analysis and could result in non-risky insurers being designated as systemically risky and systemically risky insurers avoiding designation,” the briefing paper states.

The Geneva Association further cautioned “more consideration should be given to any possible unintended consequences that could arise for the insurance sector as well as the wider economy from measures that will change inter alia, the investment incentives, the competitive landscape and underwriting practices of our industry.”

The think-tank notes “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.” 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,” the association’s press release adds.

Speculative derivatives trading on non-insurance balance sheets and the mismanagement of short-term funding are two activities with the potential to create systemic risk as defined by the Financial Stability Board’s criteria, notes the briefing paper. “Any potential policy measure resulting from this process should reflect the drivers of systemic risk and create the right incentives for companies to manage them appropriately.”