Jeffrey Wade
Systemic risk refers to the possibility that an event at the company level could trigger severe instability or even collapse an entire industry or economy. In the context of insurance, systemic risk is generally considered to be low due to the fragmented nature of the industry, with the national insurance marketplace spread among thousands of companies. However, in recent years, the life insurance sector has become more systemically important, particularly in advanced economies, due to growing common exposures and increased interest rate sensitivity. This has led to a rise in exposures to aggregate risk, indicating that insurers are more likely to be adversely affected alongside other segments of the financial sector. The failure of a systemically important insurer or the collective failure of several insurers could have a cascading effect, posing a significant systemic risk to the financial system.
| Characteristics | Values |
|---|---|
| Definition | Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. |
| Applicability | Systemic risk is not limited by its mathematical approaches, model assumptions, or focus on one institution. |
| Sources | Sources of systemic risk can be entity-based or activity-based. |
| Impact | The impact of systemic risk goes beyond the institution's products and activities to include the economic multiplier of all other commercial activities dependent on that institution. |
| Assessment | There are two key assessments for measuring systemic risk: the "too big to fail" (TBTF) and the "too (inter)connected to fail" (TCTF or TICTF) tests. |
| Insurance Sector | The insurance sector's contribution to systemic risk has increased since the Global Crisis due to growing common exposures and rising interest rate sensitivity. |
| Macroprudential Approach | Supervisors and regulators should adopt a macroprudential approach to the insurance sector to address systemic risk arising from common exposures. |
| Regulation | Post-crisis regulation has been implemented to ensure that banks have recovery and resolution plans in place to limit the contagion of systemic risk. |
| Financial Stability | The financial crisis of 2008 highlighted the need for policies to avoid contagion and contribute to financial stability. |
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What You'll Learn
- Systemic risk in insurance is unlikely, according to GFIA
- The life insurance sector has become more systemically important
- Common exposures and interest rate sensitivity are contributing factors
- Systemic risk can be caused by the failure of a single insurer
- Macroprudential policies are needed to mitigate systemic risk
Systemic risk in insurance is unlikely, according to GFIA
The Global Federation of Insurance Associations (GFIA) has consistently argued that conventional insurance is not systemically risky. According to GFIA, systemic risk in insurance can only arise from a small number of activities undertaken on a large scale under specific adverse conditions. The GFIA highlights the significant differences between the insurance industry and other financial industries, particularly banking, and emphasizes that insurance failures are rare and their impact on financial stability is extremely limited.
The GFIA's position is supported by the fact that the insurance industry is highly regulated and has a stable, long-term business model that safeguards people and businesses from financial hardship. Insurers also have less exposure to systemic and liquidity risks compared to banks and non-bank financial institutions (NBFI). The NBFI sector, which includes investment and money market funds, private equity funds, venture capitalists, microloan organizations, and cryptocurrencies, is only lightly regulated and highly interconnected with other areas of the financial system and the real economy. In contrast, the insurance sector has limited interconnectedness, a low risk of a run against an insurer, and better alignment between assets and liabilities.
Furthermore, GFIA advocates for an activity-based approach to assessing systemic risk rather than an entity-based assessment. The Holistic Framework, developed by the International Association of Insurance Supervisors (IAIS), is a well-functioning framework that reflects the unique business model of insurance and increases the sector's resilience. This framework has been effective in minimizing potential shocks to the financial system, as demonstrated during the market distress caused by COVID-19, where insurance acted as a shock absorber rather than amplifying vulnerabilities.
While the life insurance sector has become more systemically important in advanced economies due to increasing common exposures and rising interest rate sensitivity, the systemic risk contribution remains below that of the banking sector. The non-life insurance sector's systemic risk has also not increased significantly. Nevertheless, supervisors and regulators should adopt a more macroprudential approach, paying particular attention to smaller and weaker firms that may take on excessive risks.
In summary, GFIA maintains that systemic risk in the insurance industry is unlikely due to its unique characteristics, robust regulation, and limited interconnectedness. The Holistic Framework further strengthens the sector's resilience and ability to manage potential systemic risks effectively.
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The life insurance sector has become more systemically important
Systemic risk is a type of endogenous risk that can be defined as the likelihood and degree of negative consequences to the larger body. It is important not to confuse systemic risk with market or price risk, as the latter is specific to the item being bought or sold.
The rise in exposures to aggregate risk means that insurers are more likely to be adversely affected alongside other segments of the financial sector. In the event of an adverse shock, insurers will likely fail to fulfil their role as financial intermediaries when other parts of the system are also failing. This highlights the importance of supervisors and regulators taking a more macroprudential approach to the sector.
Reinsurance chains have become more complex, and the life insurance sector has become more interconnected, with rising amounts of risks migrating across entities and jurisdictions. This has made it more difficult to assess how risks could propagate through the system, emphasising the importance of rigorous group-wide supervision, systemic risk analysis, and international cooperation.
While the life insurance sector has become more systemically important, it is important to note that the sector's systemic importance remains below that of the banking sector.
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Common exposures and interest rate sensitivity are contributing factors
The life insurance sector has become more systemically important in advanced economies, with common exposures and rising interest rate sensitivity being key contributing factors. Firstly, common exposures within the industry and to the broader economy have increased. This means that insurers are more likely to be adversely affected alongside other segments of the financial sector. This is not due to overt portfolio shifts, but rather duration mismatches and broader market forces. For example, during an adverse shock, insurers may be unable to fulfil their financial intermediary roles when other parts of the system are also failing.
Secondly, rising interest rates can affect the profitability of insurance companies. Insurance companies have substantial investments in interest-rate-sensitive assets, such as bonds, and market interest rate-sensitive products for their customers. When interest rates increase, the opportunity cost of holding bonds over a long period increases, and the value of a bond or other fixed-income investments will decrease. This can make it harder for insurance companies to sell their bonds, affecting their profitability.
However, the impact of rising interest rates on insurers is nuanced. On the one hand, higher interest rates can make equity-indexed life insurance and annuities less attractive to policyholders. On the other hand, insurers will be in a better position to offer insured products with more substantive interest rate guarantees. Additionally, rising rates tend to mean rising profits for insurers as they can add higher-yielding assets to their portfolios.
Overall, the life insurance sector's contribution to systemic risk has increased due to growing common exposures and interest rate sensitivity. This highlights the need for supervisors and regulators to adopt a more macroprudential approach to the sector, ensuring that common exposures and interest rate sensitivity do not lead to systemic risks that could destabilize the financial system.
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Systemic risk can be caused by the failure of a single insurer
Systemic risk refers to the possibility that an event at the company level could trigger severe instability or even collapse an entire industry or economy. In the context of insurance, systemic risk can indeed be caused by the failure of a single insurer, which can have a domino effect on the wider financial system. This is particularly true if the insurer is "too big to fail" (TBTF) or "too (inter)connected to fail" (TCTF or TICTF). These terms refer to institutions that are large relative to their industry or make up a significant part of the overall economy, and their collapse could have far-reaching consequences.
The failure of a single insurer can lead to systemic risk in several ways. Firstly, it could be due to the insurer's size and market share concentration. If an insurer has a significant market presence and fails, it could create a vacuum in the market, disrupting the balance and causing instability. Secondly, it relates to interconnectedness. Insurers are often highly interconnected with other financial institutions, and their failure could have a ripple effect on other companies and sectors. This was evident during the 2008 financial crisis when the collapse of American International Group (AIG) posed a significant systemic risk due to its interconnectedness with other financial institutions.
Moreover, the failure of a single insurer can lead to a loss of confidence in the insurance sector as a whole, causing a wider impact on the financial system. Insurers play a crucial role as financial intermediaries, and their failure to fulfil this role during times of economic shock can have systemic consequences. This is especially true if the failure occurs during a period of economic downturn or if the insurer is a specialist in a specific market segment, which could lead to a cascade of failures and further economic instability.
While the insurance sector's contribution to systemic risk is generally considered lower than that of the banking sector, it is important to recognise that the life insurance sector, in particular, has become more systemically important in advanced economies due to growing common exposures and increased interest rate sensitivity. This highlights the need for supervisors and regulators to adopt a macroprudential approach, focusing on the financial system as a whole rather than individual entities, to effectively mitigate systemic risk in the insurance industry.
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Macroprudential policies are needed to mitigate systemic risk
Systemic risk in the insurance sector has been a growing concern in recent years, particularly in the aftermath of the 2007-2009 financial crisis. This risk is not limited to financial factors but also encompasses political, environmental, and other domains. The life insurance sector, for instance, has become increasingly systemically important, with insurers taking on more risk and becoming more interconnected with the rest of the economy.
The Global Federation of Insurance Associations (GFIA) has argued that conventional insurance is not systemically risky and that an entity-based assessment of systemic risk is inappropriate. However, the increase in systemic risk contribution in the insurance sector, coupled with higher common risk exposures, calls for a more nuanced approach. Macroprudential policies are needed to address these risks and ensure financial stability.
Macroprudential policies provide regulatory governance of the overall financial system. They aim to prevent financial disruptions and preserve financial stability by assessing systemic risks within the financial sector. These policies are designed to address the interconnectedness of financial sectors, such as the insurance industry's links with commercial banking. By adopting these policies, regulators can monitor and respond to the impact of external financial and economic risks on the insurance industry and vice versa.
The NAIC's Macroprudential Initiative (MPI), for example, was established to enhance the credibility of the state system of insurance regulation and increase public awareness of its capabilities to assess macroprudential risks. Similarly, the GAO (U.S. Government Accountability Office) has developed a framework for evaluating macroprudential policies to mitigate risks to the financial system's stability. This framework includes six general components, 18 principles, and related standards to guide the implementation of such policies.
In conclusion, macroprudential policies are essential for mitigating systemic risk in the insurance sector. By adopting these policies, regulators can ensure financial stability, protect policyholders, and enhance the resilience of the financial system as a whole.
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Frequently asked questions
Systemic risk is the possibility that an event at the company level could trigger severe instability or even collapse an entire industry or economy.
Systemic risk in insurance refers to the potential for an insurer or group of insurers to cause widespread disruption to the financial system and the real economy. This could be due to the failure of a systemically relevant insurer or the collective failure of several insurers, known as the "cascade effect".
While the insurance sector has become more systemically important, particularly in advanced economies, it is still less systemically risky than the banking sector. This is because the insurance marketplace is spread among thousands of companies, and the barriers to entry are relatively minor.
Systemic risk in insurance can be mitigated by adopting a macroprudential approach that focuses on the financial system as a whole, rather than individual entities. This includes implementing capital and transparency standards, as well as paying closer attention to smaller and weaker firms that are more likely to take on excessive risks.
