Chapter

11 Systemic Implications of the Financial Market Activities of Insurance and Reinsurance Companies

Author(s):
Garry Schinasi
Published Date:
December 2005
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Insurance and reinsurance companies are an important and growing class of financial market participants. They insure a wide variety of business and household risks, thereby facilitating economic and financial activity. In addition, amid a drive to raise profitability they have become increasingly important investors and intermediaries in a broad range of financial markets around the globe. Such companies bring innovative insurance approaches to capital markets, providing insurance coverage for financial risks, intermediating their own insurance risks in the markets, and in the process developing new instruments that help bridge the gap between banking and insurance products. Insurers and reinsurers have broadened the range of available instruments, increased the diversity of market participants, created new opportunities for corporations and financial institutions to fund their activities and hedge risks, and contributed to liquidity and price discovery in primary and secondary markets.124

Compared with knowledge about commercial and investment banking activities, much less is known about the financial activities of insurance and reinsurance companies and the overarching environment in which these companies conduct their core businesses. The lack of information on insurers became known and of concern to policymakers after the bursting of the global equity-market bubble in early 2000. Many insurance companies in some countries, particularly in Europe, experienced large losses on their equity portfolios (in some cases driving them into insolvency), which had grown substantially as a result of the heavy investments they made in equities during the mid- to late 1990s as the bubble was inflating. Insurance and other financial regulators then realized that they did not have sufficient information about the capital market activities of insurers, and that prudential regulations for insurers may not have kept pace with the growing market orientation of insurers’ balance sheets.

This chapter fills part of the information and analysis gap by identifying issues likely to attract increasing attention and that may have medium-term implications for financial stability or efficiency. The first section of this chapter discusses the size and structure of insurers’ and reinsurers’ financial activities and how that size and structure have evolved in recent years. The second section explores some of the more forward-looking financial stability issues, including those surrounding a number of uncertainties about insurers’ and reinsurers’ financial market activities, and the attendant potential implications for financial efficiency and stability in the medium term.

Insurance and Reinsurance Companies’ Financial Activities

Insurance companies’ asset holdings grew substantially during the 1990s, even relative to banks’. Between 1990 and 2001 (the latest year for which there is complete and comparable data) the financial assets of insurers in six major countries grew by about 130 percent to $9.7 trillion, while the assets of banks in the same countries grew by 50 percent to $21.6 trillion (Figures 11.1 and 11.2).125 In most countries, insurance companies hold larger amounts of financial securities than do banks (Figure 11.3). Moreover, their holdings of international and domestic securities are large relative to domestic markets (Figure 11.4).126 For example, U.S. insurers are the largest domestic investors in corporate and foreign bonds (Figure 11.5). Insurance companies’ large asset pools are invested conservatively, consistent with regulatory restrictions, although the composition of asset portfolios varies substantially across countries (Figures 11.6 and 11.7).127

Figure 11.1.Shares of Total Financial Assets of Institutional Investors and Banks: United States and Japan

Sources: OECD, Institutional Investors Yearbook, various years; and OECD, Bank Profitability: Financial Statements of Banks, various years.

Figure 11.2.Shares of Financial Assets of Institutional Investors and Banks: Selected Euro Area Countries and the United Kingdom

Sources: OECD, Institutional Investors Yearbook, various years; and OECD, Bank Profitability: Financial Statements of Banks, various years.

Note: Selected euro area countries are Germany, France, and Italy.

Figure 11.3.Holdings of Financial Securities by Insurance Companies and Banks

(Billions of U.S. dollars)

Sources: OECD, Institutional Investors Yearbook, various years; and OECD, Bank Profitability: Financial Statements of Banks, various years.

Figure 11.4.Holdings of Securities Relative to Domestic Market Size

(Percent)
(Percent)

Sources: OECD, Institutional Investors Yearbook, various years; and OECD, Bank Profitability: Financial Statements of Banks, various years.

Note: Bank holdings include resident and nonresident holdings.

1For Germany, France, and Italy data refer to resident and nonresident holdings.

2For Germany and France data refer to resident and nonresident holdings.

3Holdings of shares include resident and nonresident holdings.

Figure 11.5.United States: Corporate and Foreign Bonds

(As a percentage of total amounts outstanding; end of period)

Source: U.S. Board of Governors of the Federal Reserve System, Flow of Funds.

Figure 11.6.Balance Sheet Assets of Insurance Companies: United States and Japan

Source: OECD, Institutional Investors Statistical Yearbook, various issues.

1Bills and bonds issued by residents (R) and nonresidents (NR).

Figure 11.7.Balance Sheet Assets of Insurance Companies: Selected Euro Area Countries and United Kingdom

Source: OECD, Institutional Investors Statistical Yearbook, various issues.

Note: Selected euro area countries are France, Germany, and Italy.

1Bills and bonds issued by residents (R) and nonresidents (NR).

In addition to investing, life insurance companies participate in financial markets by offering retail financial products in the form of hybrid insurance contracts-mutual funds. These are growing rapidly in some countries. In the United States, about half of all new life insurance policies are unit-linked (linked to market returns). Such products are also popular in Europe, where they may have tax advantages over mutual funds. In Italy, single-premium, unit-linked products are offered; these products exchange a large up-front payment for a mutual fund that incorporates a life insurance policy. Such products are often sold through bancassurance groups, which are joint ventures between banks and insurance firms.

Investments As a Response to Underwriting Losses

The overall profitability of an insurance company depends on the net profitability of its insurance underwriting and financial activities. Three main factors influence this profitability:

  • The incidence and size of claims. Notable increases in nonlife insured losses arose following Hurricane Andrew in 1992, the attacks of September 11 in 2001, and natural disasters in 2004 (Figure 11.8).
  • The prevailing level of premiums. During the 1990s and early 2000s, premiums tended to grow at an inflation-adjusted rate of about 5 percent (higher for life, lower for nonlife before 2000)—well below average rates attained during the 1980s (see Figure 11.8 and Table 11.1).
  • The performance of financial markets. Since the early 1980s, insurance companies in the major countries have been increasingly successful in reaping investment returns that compare favorably with the yield on domestic government bonds (see Figure 11.8).

Figure 11.8.Global Insurance Industry Results

Source: Swiss Re Economic Research & Consulting.

Table 11.1.Life Insurance: Premium Growth Rates
Single Premiums as a

Percent of Total Life Business
Average Annual Growth

Rates 1995–2003 (percent)
Average Annual Growth

Rates 2000–2003 (percent)
199520002003Single PremiumsAnnual PremiumsSingle PremiumsAnnual Premiums
United States112.715.618.26.60.56.70.4
Japan9.86.816.74.7–2.135.10.1
United Kingdom47.476.971.414.81.7–10.5–1.0
France69.271.7
Germany9.311.613.07.12.15.11.0
Italy236.960.170.631.08.722.7–4.5
Netherlands38.746.347.110.26.72.01.6
Switzerland48.855.450.83.42.4–2.83.3
Source: Swiss Re Economic Research & Consulting.

Only personal life business.

Figures for 2003 are estimates.

Source: Swiss Re Economic Research & Consulting.

Only personal life business.

Figures for 2003 are estimates.

Since the mid-1990s, insurance loss ratios (relative to premiums) ranged from 57.2 percent in Japan to 82.9 percent in France (see Table 11.2, which focuses on nonlife companies). Expense-to-premium ratios ranged from 22.4 percent in France to 35.2 percent in Japan. Adding these two ratios into the “combined ratio” gives a standard, widely used measure of the overall profitability of an insurance company’s core underwriting business (apart from the return on its market investments). As Table 11.2 and Figure 11.9 show, during 1995–2003, in most countries, nonlife insurers had combined ratios above 100 percent, implying that on a cash-flow basis and excluding investment returns, insurance underwriting was loss-making. Except in Japan, losses plus expenses exceeded premiums by 0.1 percent to 7.6 percent (“Underwriting result” line in Table 11.2). In Japan, returns on underwriting were 2.2 percent.128

Table 11.2.Profitability Decomposition of Major Nonlife Insurance Markets(Percent of net premiums)
United States

1995–2003
Canada

1996–2003
United Kingdom

1996–2003
Germany

1995–2003
France

1995–2003
Italy

1995–2003
Japan

1995–2003
Loss ratio79.174.569.471.182.981.057.2
Expense ratio26.630.431.826.022.424.235.2
Underwriting result1–7.6–5.7–7.1–0.1–6.8–6.12.2
Investment yield26.67.18.46.95.94.22.5
Asset leverage262.5205.2220.3221.0223.5198.4446.13
Net investment result16.815.118.814.813.09.39.9
Other expenses to earnings–1.20.30.8–1.9–1.51.6–9.2
Profit margin (pre-tax)9.29.712.512.84.74.82.9
Tax rate18.435.710.541.328.938.558.84
Profit margin (after-tax)7.26.511.07.43.03.11.2
Solvency98.687.078.4128.8598.2
ROE27.37.414.35.753.2
Source: Swiss Re Economic Research & Consulting.Note: Loss, expense, policyholder dividend and combined ratios for the United States, Canada, and the United Kingdom are net of reinsurance, whereas for Germany, France, Italy, and Japan they are for direct business (prior to cessions to reinsurers).

Includes policyholder dividend.

Investment result in percent of assets of previous year.

Includes reserves for maturity-refund policies, which are about 45 percent of assets and 30 percent of premiums.

Excludes 1999 because in 1999 taxes were paid despite pre-tax losses, resulting in a calculated negative 631 percent tax rate for 1999.

1997–2003

Source: Swiss Re Economic Research & Consulting.Note: Loss, expense, policyholder dividend and combined ratios for the United States, Canada, and the United Kingdom are net of reinsurance, whereas for Germany, France, Italy, and Japan they are for direct business (prior to cessions to reinsurers).

Includes policyholder dividend.

Investment result in percent of assets of previous year.

Includes reserves for maturity-refund policies, which are about 45 percent of assets and 30 percent of premiums.

Excludes 1999 because in 1999 taxes were paid despite pre-tax losses, resulting in a calculated negative 631 percent tax rate for 1999.

1997–2003

Figure 11.9.Nonlife Insurance: Combined Ratios in the Industrialised Countries

(In percent)

Source: Swiss Re Economic Research & Consulting.

Nonlife insurers in the countries in Table 11.2 made up for underwriting losses, or augmented underwriting returns, through investment. Investment yields ranged from 2.5 percent in Japan (reflecting low government bond yields and declining stock prices) to 8.4 percent in the United Kingdom, and translated into net investment results (expressed as a percent of premiums) ranging from 9.3 percent to 18.8 percent. Net of taxes and other expenses, underwriting and investment results translated into profit margins from 1.2 percent (Japan) to 11.1 percent (United Kingdom), and returns on equity from 3.2 percent (France) to 14.3 percent (United Kingdom).

In the life insurance industry, reaping strong investment returns has been especially important for companies that have high guaranteed rates of nominal return on existing policies. In the 1980s and early 1990s, insurance companies offered high guaranteed returns on insurance policies, reflecting the ability to earn very strong market returns on asset portfolios, high premium incomes, and in some countries, high minimum rates mandated by regulators. As nominal bond yields sank during the 1990s amid declining inflation and the euro area convergence process, meeting these guarantees became more challenging. In Japan and Switzerland, government bond yields slid below guaranteed rates on existing policies.

During the 1990s, insurers responded to an environment of lower real premium growth by managing asset portfolios more actively and shifting the asset mix. Between 1990 and 2001, insurers’ investments in corporate equities rose from 17 percent to 27 percent in the euro area, from 53 percent to 61 percent in the United Kingdom, and from 10 percent to 26 percent in the United States (see Figures 11.6 and 11.7).129 In addition, the development of emerging markets and corporate bond markets, including the market for lower-rated credit instruments, offered insurance companies opportunities to raise investment returns. Active asset management together with realized capital gains from rising bond and share prices enabled insur-ance companies in most countries to earn an investment yield above that of the long-term government bond yield in their home country (see Figure 11.8).

Shift into Newer Financial Market Activities

In the 1990s, periods of soft premiums and low bond yields also spurred innovations that fostered convergence between insurance and capital markets. Insurers divested less profitable insurance risks in the form of catastrophic risk (“Cat”) bonds—bonds with payoffs linked to a catastrophic event. Reinsurers also diversified their insurance business by developing the profitable “alternative risk transfer” (ART) market for customized reinsurance products that bridge the gap between traditional insurance and banking products.130 Examples include contingent capital, which gives an insurance company the option to replenish its capital if it is adversely affected by a natural catastrophe; captive insurance, which permits large conglomerates to insure themselves by pooling risks in a separate entity; and finite reinsurance, which is a form of self-insurance that permits a policyholder to spread an insurance loss over a predetermined period of time.

Insurance companies also sought to diversify their large investment portfolios and funding sources. For example, they became more important participants in credit derivatives markets, helping banks to hedge and diversify their credit exposures.131 Market participants indicate that insurance companies are more active buyers of collateralized debt obligations (CDOs), private equity, funds of hedge funds, and reverse convertible securities. On the funding side, U.S. life insurance companies have issued funding arrangements (FAs) and guaranteed investment contracts (GICs), issuance of which grew rapidly to about $40 billion to $50 billion in 2001 (JP Morgan, 2001). According to market participants, funds so generated were generally invested in higher-yielding securities with similar maturities to the FA/GIC, generating a positive spread.

In 2001, the deterioration in credit and equity markets and huge claims associated with September 11 adversely affected insurers’ profits and caused the failure of a few weaker, lower-tier institutions. Subsequently, an improved appreciation of the risks in newer activities, and a firming of insurance premiums amid an increase in demand for insurance, led a number of insurance companies to reevaluate their capital markets activities. In addition, market participants suggest that a number of less-active firms withdrew from activities such as ART and credit derivatives. As a consequence, these newer activities are concentrated among a few large players. Over time, higher premiums may heighten competition in the insurance business, putting downward pressure on premiums and leading to a renewed interest in newer, more profitable activities.

Financial Efficiency and Stability Questions Raised by Insurers’ Financial Activities

As noted, relatively little is known about the environment in which insurance and reinsurance companies conduct their financial market activities, and about how the existing regulatory framework should address resulting issues. The remainder of this chapter examines five forward-looking financial stability issues to broaden the understanding of the challenges that lie ahead for the insurance and reinsurance industries and more generally for the international financial community:

  • the balance between official oversight and market discipline;
  • information about financial markets activities;
  • the legal frameworks for insurance and financial markets;
  • leverage in individual firms and the overall industry;
  • systemic implications, if any, of insurance and reinsurance company instability.

Official Oversight and Market Discipline

As with commercial and investment banking, the soundness of insurance and reinsurance companies and the financial stability of these industries rely on both official oversight and private market discipline. The regulatory and supervisory framework for the insurance industry is primarily oriented toward policyholder protection; thus, it ensures that reserves and capital are adequate and that investments are relatively safe and liquid, so that insurers can pay claims and other cash flows to policyholders on a timely basis. Insurers usually face restrictions on the concentration of balance-sheet investments in asset classes such as fixed income, equity, and real estate.132 Regulation of off-balance-sheet instruments ranges from broad guidelines to outright prohibition of derivatives transactions that do not directly hedge risks associated with insurance business.133

Reflecting its policyholder-protection orientation and the fact that insurers are not deposit-taking institutions, official oversight of the insurance industry in many jurisdictions is less focused on financial market risks when compared with the official oversight of commercial banks. For example, European Union capital requirements reflect the volume of insurance business exclusively. In Australia, Canada, Japan, and the United States the regimes include capital charges for risks on the asset side of the balance sheet, but questions nonetheless remain about whether capital fully reflects the underlying risks.134 The major Australian insurer HIH filed for liquidation in March 2001, but its administrator reported that it was insolvent as early as June 2000 and possibly earlier. In Japan, questions arise about the quality of capital, which may include deferred tax credits and one year’s future income, and the adequacy of risk weights for equity and other exposures.

Reinsurance regulation is less uniform across countries than insurance regulation. In some countries—the United Kingdom and the United States, as well as Denmark, Finland, and Portugal—reinsurers face regulations similar to those applied to primary insurers; in others they are unsupervised. Many reinsurers are located in offshore centers where they face particularly light regulation and supervision, reflecting a view that the wholesale participants in the reinsurance market are more sophisticated and well informed than the retail participants in the primary insurance market, and therefore are better able to assess the risks of their counterparties. Nevertheless, the limited regulation of reinsurers in some jurisdictions has raised concerns that reinsurance regulation may need strengthening, and that reinsurance arrangements may reduce the transparency of insurance company accounts and transfer less risk than is apparent.135

Supervisory frameworks for insurers and reinsurers have been under active discussion in the official community. The Joint Forum of banking, securities, and insurance supervisors has underscored key differences in risk management practices and regulatory capital requirements across the three sectors (Joint Forum, 2001a and 2001b). The Forum more recently clarified the difficult challenges in enhancing disclosure and transparency in the insurance industry, and in the financial industry more generally (Joint Forum, 2004) and in 2005 published the findings of its study of the credit risk transfer market, including the involvement of insurance companies (Joint Forum, 2005). The International Association of Insurance Supervisors (IAIS) “Principles on Capital Adequacy and Solvency” recommends that capital adequacy and solvency regimes should be sensitive to risks in investments and off-balance-sheet exposures. The IAIS also developed principles for the supervision of reinsurance companies (IAIS, 2002a) and published a set of core principles for supervisory insurers (IAIS, 2003). In the European Union, the 2002 EU “Solvency I” Directives improved solvency requirements, increased supervisors’ powers for early intervention, and allowed member states to put in place more stringent solvency requirements. An ongoing “Solvency II” project—scheduled to replace Solvency I in 2007—is considering issues including asset-liability matching, treatment of reinsurance cover, accounting and actuarial policies, and “double gearing” within financial conglomerates (a situation in which two companies structure a transaction in which they each have a claim on the same capital).136 In addition, observance of insurance core principles in IMF member countries are assessed under the IMF/World Bank Financial Sector Assessment Program (FSAP) (see IMF and World Bank, 2001). Because official oversight is oriented more toward policyholder protection than managing financial market risks, the soundness of insurers and reinsurers relies heavily on market discipline. For example, credit rating agencies inform policyholders and creditors about insurers’ financial strength and insurers strive for high ratings to maintain investors’ and policyholders’ confidence. In addition, risk managers at some banks partly rely on credit ratings in evaluating their counterparty risk exposures to insurers and the risks in financial products sold by insurers. Finally, counterparties increasingly use Standard and Poor’s assessments of risk-based capital that are based on its proprietary capital adequacy model.

Reflecting these considerations, market participants—and some officials—regard the credit rating agencies as the de facto regulators for insurers and reinsurers.137 Ratings agencies are uncomfortable with this perception and role. Seasoned analysts consider insurance companies to be opaque and complex, and find it difficult to fully evaluate insurers’ financial market activities and assess whether the risks are well managed. Similarly, some counterparty institutions of insurers and reinsurers question whether ratings fully reflect the potential counterparty risks. These institutions have further developed their internal credit analysis of their exposures to insurers and reinsurers and tightened counterparty risk management, sometimes by taking more collateral.

Disclosure and Transparency

Less information seems to be available—to officials and private financial stakeholders—on the market activities of insurance companies than on the activities of commercial and investment banks, particularly in four areas.

First, official data to assess whether capital adequately supports insurers’ financial risks is limited. Regulatory reports typically contain sparse information on risks in the asset side of the balance sheet and on off-balance-sheet activities in the derivatives markets. In addition, features of accounting standards in the insurance industry, such as limited application of mark-to-market or fair-value accounting to liabilities, and the opacity of actuarial assumptions underlying valuations, may reduce the usefulness of reported data.

Second, relatively little is known about whether insurance companies’ management of market and credit risks has kept pace with their growing involvement in the markets. Although some major insurers have sophisticated financial modeling systems, market participants, credit rating agencies, and officials have raised questions about the effectiveness of some insurers’ and reinsurers’ internal risk management and controls for managing their asset-market activities as well as the market risks (mostly interest-rate risk) embedded in their liabilities.138 For example, life insurers have relied on careful analysis of mortality probabilities, based on detailed and lengthy panel data, in pricing insurance premiums. Because mortality risk is relatively stable over time, profit and loss flows on portfolios of life insurance contracts have been fairly predictable. Market participants suggest that some insurers have tried to adapt the actuarial approach to managing the risks in their financial activities. This strategy has drawbacks, particularly for credit investments where data are lacking and where default probabilities can change sharply and unpredictably with economic and financial developments. These insurers have reportedly since bolstered their credit risk analysis to bring it closer to the standards attained by banks, but the actual extent of progress is unknown.139

Third, regulatory and shareholder reports do not consistently disclose the size of, or amount at risk in, off-balance-sheet positions, or the extent to which derivatives are used for hedging rather than yield enhancement. The only aggregate information on insurers’ involvement in over-the-counter (OTC) derivatives appears to be the survey figures compiled by the British Bankers’ Association on the credit derivatives market (British Bankers’ Association, 2004).

Fourth, the migration of financial risks between insurance companies and other financial institutions makes it more challenging to track the distribution of risks in financial systems,140 raising questions about the extent to which insurance companies are participating in segments such as CDOs and asset-backed commercial paper. There are also questions about the extent to which financial institutions have used financial insurance contracts, particularly in place of derivatives contracts, to hedge financial risks.

Legal Risks in Financial Insurance Contracts

Financial insurance contracts between insurance companies and the internationally active commercial and investment banks have given rise to some high-profile legal disputes. For example, in the “Hollywood Funding” transactions of 2001, structured notes issued to finance a number of films to be made by Flashpoint Ltd. included credit enhancements in the form of insurance policies written by Lexington Insurance, a subsidiary of American International Group. Bondholders evidently understood the credit enhancements to be in the form of credit guarantees, which require the insurer to pay the bondholders upon default. Lexington argued that the contracts allowed it to refuse to pay if a specified number of films were not produced, and also allowed it to dispute or investigate claims prior to paying. Flashpoint never made any films, and Lexington asserted a right to investigate the claim and delay payment.

In another high-profile case, JP Morgan and Enron were counterparties in forward contracts involving physical delivery of natural gas and oil to JP Morgan. JP Morgan obtained surety bonds from insurance companies to mitigate the risk that Enron would fail to deliver.141 When Enron filed for bankruptcy protection, JP Morgan sought payment of $965 million on these bonds from the insurers. The insurers refused to pay on the grounds that the counterparties never intended to settle the forward contracts with physical delivery, and claimed that the contracts were a front to obtain the surety bonds as collateral against what JP Morgan and Enron intended as loans from JP Morgan to Enron. JP Morgan allegedly used the surety bonds instead of credit derivatives because the bonds cost much less—perhaps 90 percent less—than credit default swaps (Kochan, 2002). The case was settled out of court just before it was due to go to jury trial in January 2003: JP Morgan received about $600 million from the insurers and took a pre-tax charge of about $400 million to recognize the net loss from the transaction.

These two disputes illustrate the key differences in the legal and operational frameworks underlying insurance and financial contracts. For example, under U.K. law, insurers can delay payment by invoking a “material disclosure” provision to claim that their financial insurance counterparty withheld material information about the underlying risk. By contrast, no such provision applies to OTC derivatives documented under International Swaps and Derivatives Association (ISDA) contracts. In addition, ISDA contracts require immediate payment, whereas insurance contracts may pay off over a period of years, particularly if insurers exercise their right to dispute the claim.

Reflecting these disputes, some of the major global banks no longer use insurance instruments to manage financial risks and instead use ISDA derivatives contracts, particularly when dealing with insurers. Others have become highly selective in choosing insurance transactions and in choosing counterparties that have a track record of timely payment. In addition, some London market participants now craft contracts to limit the use of “material disclosure” provisions. One major rating agency now examines “willingness to pay” when rating insurance policies used to provide credit enhancements or financial guarantees. Notwithstanding this progress, the understanding and management of these risks still need to evolve.

Leverage

At first glance, balance sheet information suggests that insurance companies are typically overcapitalized to a much larger extent than commercial banks. Major insurers’ capital ratios often exceed the regulatory minimum by two to four times, compared with approximately one to two times for banks (Joint Forum, 2001b, p. 53). A closer look suggests that insurers hold excess capital in part to cover financial risks not covered in their regulatory requirements. As noted earlier, capital requirements in some countries primarily reflect insurance risks—the liability side of the balance sheet—rather than investment risks on the asset side. Rating agencies and counterparties therefore look for capital ratios that are well above minimum standards. In their view, insurers are becoming more sensitive to risk-based capital allocation and are moving to upgrade their internal capital management systems.

Despite this progress, questions have been raised about whether some Japanese and European insurance companies are adequately capitalized on a risk-adjusted basis relative to their financial and insurance risks.142 For example, insurance companies’ capital may not fully reflect the substantial implicit options embedded in their balance sheets. On the asset side, some insurance companies hold securities such as convertible bonds that have embedded options. On the liability side, many life insurers have issued guaranteed return policies that amount to call options on interest rates sold to policyholders. Falling interest rates increase both the value of these options to policyholders and the implicit corresponding liability for insurers. For a variety of insurance companies, market returns on safe instruments have fallen below promised rates on existing policies originated earlier. In Japan, guaranteed returns average 4 percent, compared with investment returns of less than 2 percent; in Switzerland, insurers are mandated to offer guaranteed returns of 4 percent on compulsory private “second-pillar” pensions, compared with 10-year bond yields of about 3.6 percent.

There are also broader questions about whether capital in the global insurance and reinsurance industry is sufficient to support prudently the total amount of insurance risk in the global financial system, both presently and in the immediate future as demand for insurance products grows. The global insurance industry experienced significant shocks in the period 2001–2004 (see middle panel of Figure 11.8). In 2001, total insured losses to the nonlife industry from natural disasters were estimated to have amounted to $11.5 billion, up from $7.5 billion in 2000. Equity market declines were estimated to have erased some $20 billion from insurers’ balance sheets. Enron’s collapse was estimated to result in $4 billion to $5 billion in losses on securities and insurance policies. The terrorist attacks in the United States on September 11, 2001, were estimated to have cost insurers $50 billion to $60 billion worldwide. Finally, a string of natural disasters in the period 2002–2004, culminating in the Asian tsunami, are estimated to have cost insurers some $70 billion. Overall, these estimated losses total some $160 billion, only about $20 billion to $30 billion of which has been replaced by fresh inflows of capital (total capital in the insurance industry is estimated to have been around $480 billion in 2002).143

Possible Systemic Financial Problems of Insurance Company Failure

Extensive discussions with both market participants and officials suggest the international financial community believes that insurance company insolvencies would be unlikely to have systemic effects on financial stability, for several reasons. First, in most cases the existing combination of market discipline and official oversight seems to have detected and addressed insurers’ financial fragility before it posed significant risks to financial market stability, notwithstanding the fact that some problems have been privately and socially costly. For example, the March 2001 failure of Australian insurer HIH does not seem to have caused significant or persistent volatility in either Australian or global capital markets, despite its international presence, including operations in Europe, Asia, North America, and Latin America; an estimated $2.8 billion in losses for the firm; and the risk to some 2 million policyholders and a number of creditors, including globally active banks in Europe and the United States.

Second, liquidity and solvency problems involving insurance companies are generally unlikely to cause a rapid liquidation of investment portfolios—including derivatives positions—and market turbulence. In a typical insolvency proceeding, life insurers stop taking on new policies, and their remaining long-term policies—some with maturities of decades—are sold off to other insurers and are allowed to run off over a period of years. Similarly, property and casualty insurers tend to pay off claims slowly, reducing the potential immediate pressure on liquidity. On occasions when a sharp increase in insurance claims potentially puts pressure on liquidity, litigation or investigation of claims may delay payment. Financial counterparts rely increasingly on collateral arrangements to manage counterparty and credit risk exposures.

Third, the newer financial market and insurance activities, although evidently rapidly growing, are relatively small in relation to both insurers’ balance sheets and to overall capital markets. Although precise estimates of market size are not available, only about $13 billion in ART is estimated to have been issued since 1996, and total capital devoted to ART amounted to only about $20 billion in 2002. In addition, the share of CDOs held by insurers is unknown, but even if they held all of the $500 billion current total, it would constitute a small fraction of the $10 trillion in financial assets held by insurers in the major countries at the end of 2001. This suggests that a disruption in these newer activities or deterioration in these assets would be unlikely to affect the viability of a major insurer.

Conclusion

As this chapter suggests, despite limited information, many observers involved with the industry in meaningful ways are comfortable with the judgment that the international systemic risks associated with the financial market activities of insurance companies are relatively limited compared to those of the major internationally active banks and commercial banks. Nevertheless, uncertainties remain about whether insurers hold adequate capital against financial risks; whether their management of market risk has kept pace with their expanding involvement in the market, and the size and extent of their off-balance-sheet activities; and the potential migration of financial risks from banking to insurance sectors. In this light, it might be worthwhile asking whether some combination of limited information, limited regulation, and high leverage could make insurers and reinsurers more vulnerable to rapid and turbulent collapses.

An insurance or reinsurance company collapse could affect financial stability through at least two channels. First, it could affect the financial conditions of counterparty commercial banks, investment banks, and other financial institutions through direct credit exposures such as loans and credit lines. Financial stress at a large global insurance or reinsurance company could thereby adversely affect a major financial institution that plays a key role in the major payment and securities settlement systems. It could also adversely affect bank balance sheets if the affected firm were part of a bancassurance conglomerate (IMF and World Bank, 2001, p. 5). Banks that belong to bancassurance conglomerates may be more vulnerable to market risks than solo banks because of the more stringent regulatory restrictions that apply to banks’ market exposures, and may also be exposed to reputational risk if their insurance arm experiences financial distress. However, few conglomerates include both a large insurance company and a large complex banking operation. Second, the failure of a large reinsurer could adversely affect OTC derivatives counterparties and bank counterparties in credit-risk transfer transactions such as credit derivatives.

Other questions can be raised about the financial-stability implications of reinsurers’ financial problems. Major insurance companies actively hedge insurance risks with reinsurance companies and thereby have extensive counterparty relationships with reinsurers. In effect, the reinsurance companies are part of the risk management framework and an important line of defense against insurance company illiquidity and insolvency, because they help to pool the insurance risk. Over the years, counterparty exposures may have become more concentrated amid consolidation in the global reinsurance industry. This relationship poses risks: could a systemic insurance event—possibly the confluence of several major catastrophes to which a critical mass of reinsurers are exposed—create the strong potential for financial distress involving a number of reinsurers simultaneously?

If several major reinsurers simultaneously experienced financial stress, a large number of major primary insurers could be at risk that their reinsurance hedges could fail to perform as expected, and leave many primary insurers with unhedged financial and insurance exposures. It is difficult to know how insurers would rebalance their activities and exposures to manage the sudden change in their risk profiles but adjustments could include cutbacks in the provision of insurance, withdrawals from capital markets, and attempts to unwind OTC derivatives hedges and liquidate part of their portfolios to return their financial and insurance risk profiles to more desirable positions.

To assess these risks and have a more credible understanding of these potential scenarios, the international community needs better information about the financial activities of insurers and reinsurers, especially the size, extent, and nature of reinsurance cover, and the potential for a critical mass of major reinsurers to simultaneously experience financial difficulties. In addition, it may be desirable to assess further whether the limited regulation of insurers’ and reinsurers’ financial activities creates an unlevel playing field in relation to banks (Joint Forum, 2001b).

124This chapter draws on material in IMF (2002c). The author is grateful to his colleagues for the joint effort at the time, and for their permission to draw on this publication.
125The six countries are France, Germany, Italy, Japan, the United Kingdom, and the United States.
126For most countries, holdings of securities are not broken down into domestic and foreign. It is therefore impossible to make cross-country comparisons of domestic holdings relative to domestic market size.
127See Joint Forum (2001b) for more detailed explanations of regulatory restrictions.
128In the late 1990s, the positive results in Germany and Japan partly reflect accounting conventions that exclude some expenses or include investment income in the combined ratio. See Swiss Re (2001).
129Some of the shift in equity allocations may reflect stock price changes. In Japan, for example, the share of insurers’ assets allocated to equity shares shrank from 22 percent to 10 percent.
130Major reinsurers estimate return on equity in the ART business to be in the range of 20 percent to 25 percent, well above typical rates for traditional reinsurance business. (Reinsurance is insurance for insurance companies. Reinsurance products [and companies] provide insurance against some of the risks incurred by insurance companies in their insurance contracts.)
131See IMF (2002b), Chapter III. It has frequently been suggested that differences in the regulatory treatment of financial risks between banks and insurers may have created opportunities for regulatory arbitrage, but the Joint Forum cautions that “comparisons of individual elements of the different capital frameworks are potentially inappropriate and misleading” (Joint Forum, 2001b, p. 5).
132See EU Directives 92/49/EEC and 92/96/EEC, Articles 21–22, in European Commission (2002a; 2002b).
133For example, relevant EU directives provide that derivatives may be used to hedge risks or “facilitate efficient portfolio management,” whereas the German regulatory authority publishes a list of permitted derivatives instruments and restricts how they may be used.
134In 2001, the U.K. Financial Services Authority proposed the introduction of more flexible prudential standards for insurance companies, along the conceptual lines of the Basel Capital Accord’s three-pillar approach (Davies, 2001).
135IAIS (2000, p. 4); and European Commission (2002a). IAIS (2002b) discusses supervisory standards for evaluation of reinsurance cover. The chairman of the U.K. Financial Services Authority recently remarked that two collapsed U.K. insurance companies had “financial reinsurance treaties, of doubtful value, with unregulated reinsurers” (Davies, 2002).
136Information on Solvency II can be found on the European Commission’s Web site at http://europa.eu.int/comm/internal_market/insurance/solvency_en.htm#solvency2. A useful summary is provided in Annex 3 of BIS, 2003.
137For example, IAIS (2000, p. 51) refers to rating agencies as “private market supervisors.” IAIS (2002b, p. 3) notes that “reinsurers in some jurisdictions are directly supervised; other jurisdictions rely on rating agencies in assessing the security of a reinsurer.” European Commission (2002b, Chapter 9) discusses the rating agencies’ role in the market disciplining mechanism for insurance companies.
138The IAIS recently noted that “it is questionable whether insurance undertakings—and the insurance supervisors—still have adequate insight into the professionalism and appropriateness of the reinsurance companies, and in the risk exposure policy of globally active reinsurance companies” (IAIS, 2000, p. 4).
139See Financial Services Authority (2002, p. 31). European Commission (2002b, p. 53) suggests that “asset risk … is often more significant in the risk profile than many insurers believe.”
140International Monetary Fund (2002c), Chapter III, suggested that the activities of non-traditional investors in credit risk transfer markets might distort prices in credit markets.
141A surety bond is a contract issued by the surety guaranteeing that the surety will perform certain acts promised by another or pay a stipulated sum, up to a limit, in lieu of performance should the principal fail to perform. See IMF (2002b).
143There are questions about whether the nonlife industry was overcapitalized during the 1990s, but the large estimated losses relative to new inflows may have motivated the U.K. Financial Services Authority chairman’s remark that “we believe it important for the long-term health of the [nonlife insurance] industry, and its clients, that there is some strengthening of the industry’s capital base” (Davies, 2002).

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