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Systemic Features of Insurance and Banking, and the Role of Leverage, Capital and Loss Absorption

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Abstract

This paper aims at providing a conceptual distinction between banking and insurance with regard to systemic regulation. It discusses key differences and similarities as to how both sectors interact with the financial system. Insurers interact as financial intermediaries and through financial market investments, but do not share the features of banking that give rise to particular systemic risk in that sector, such as the institutional interconnectedness through the interbank market, the maturity transformation combined with leverage, the prevalence of liquidity risk and the process of money creation. The paper also draws attention to three salient features in insurance that need to be taken into account in systemic regulation: the quasi-absence of leverage, the fundamentally different role of capital and the “built-in bail-in” of a significant part of insurance liabilities through policyholder participation. Based on these considerations, the paper argues that, if certain activities were to give rise to concerns about systemic risk in the case of insurers, regulatory responses other than capital surcharges may be more appropriate.

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Notes

  1. “Financial regulation, complexity and innovation”, speech by Jaime Caruana, General Manager of the Bank for International Settlements, prepared for the Promontory Annual Lecture, London, 4 June 2014.

  2. See the debates around the mandate of the U.K.’s Prudential Regulation Authority in House of Commons Treasury Committee (2013).

  3. See, for instance, the IAIS statement in its July 2013 (IAIS, 2013a) “Policy Measures” for systemic insurers summarising its purpose: “G-SIIs are a risk to financial stability because their scope, the nature of their business and their position in the financial system is such that their distress or failure might, cause disruption to the wider financial system and the real economy” (p. 12). In the same document, one finds also that the IAIS introduces the concept of “systemic relevance”, stating that “the degree of effective separation or interconnectedness within a global insurance group is important to its systemic relevance” (p. 22).

  4. See also the comprehensive sectoral analysis in Fitzpatrick (2013).

  5. The nine companies are from the European Union (Allianz, Aviva, AXA, Generali and Prudential U.K.), from the United States (AIG, MetLife and Prudential U.S.) and from China (Ping An).

  6. The FSB first created a common framework for G-SIFIs (global systemically important financial institutions), which was deployed to banks, and starting in 2013, to insurers. “The FSB and the standard-setting bodies continue to extend the SIFI framework to other systemically important financial institutions” (see Financial Stability Board, 2013a).

  7. The lesser the degree of substitutability, that is, the possibility of other institutions taking over the service provided by the institution under consideration, the more systemic is its role. Market concentration indices are taken as a proxy for the degree of substitutability, reinforcing the size component in the overall assessment.

  8. Intra-financial assets are holdings of debt securities issued by other financial institutions (e.g. bank bonds); intra-financial liabilities are securities issued by insurance companies and held by other financial institutions.

  9. The Geneva Association (2013).

  10. http://ir.pingan.com/en/gongsizhili/fengxianguanli.shtml.

  11. “AIG was so interconnected with many large commercial banks, investment banks, and other financial institutions through counterparty credit relationships on credit default swaps and other activities such as securities lending that its potential failure created systemic risk” (Financial Crisis Inquiry Commission, 2011, p. 352).

  12. The importance of maturity transformation and leverage for systemic risk was already highlighted in the report on systemic risk and insurance by The Geneva Association in 2010.

  13. Adrian and Brunnermeier (2014).

  14. The difference between the CoVaR value conditional on the institution being in distress and the CoVaR value in the “normal” state of the institution yields the marginal contribution of a particular institution to systemic risk.

  15. Acharya et al. (2010).

  16. Brownlees and Engle (2012).

  17. Acharya et al. (2012).

  18. Acharya et al. (2010, p. 21).

  19. Billio et al. (2011).

  20. See also Kessler (2013).

  21. Source: c (essentially banks). The figure does not include the holdings of securities issued by other banks, which amount to an additional EUR 1.6 trillion.

  22. Commerzbank financial reporting, data for end-2013.

  23. Allen and Gale (2000).

  24. Munich Re (2014), including only the part labelled “reinsurance” and excluding Munich Re’s primary insurer Ergo.

  25. Baranoff (2012).

  26. Financial Crisis Inquiry Commission (2011, p. 352).

  27. The Geneva Association (2010, p. 36).

  28. See Adrian et al. (2013).

  29. See for instance Insurance Europe (2014, p. 23): In 2012 the largest components of European insurers’ investment portfolio were debt securities and other fixed income assets (42%), followed by shares and other variable-yield securities (31%). Loans represented 11% of the total”.

  30. http://www.ecb.europa.eu/stats/money/mfi/html/index.en.html.

  31. Source: ECB Statistics on Monetary and Financial Institutions (MFIs), Table 2.5 Deposits with MFIs, data for January 2015, ECB Monthly Bulletin and website.

  32. See Baluch et al. (2011).

  33. “Our analysis of the data indicates that life insurers had about 46 per cent of liabilities in the zero-to low-liquidity categories and 54 per cent in the moderate- to high-liquidity categories at the end of 2011” (Paulson et al., 2012).

  34. See The Geneva Association (2012a).

  35. Krugman and Wells (2009).

  36. www.ecb.europa.eu/mopo/implement/mr/html/calc.en.html.

  37. Legnick et al. (2012).

  38. Legnick et al. (2012, p. 1).

  39. Werner (2014).

  40. BIS (2003).

  41. One could argue that policies with the possibilities of policy loans are liquid liabilities, but such features are rare, and insurers typically have the possibility to reject such policy loans requests.

  42. Elliott (2013).

  43. The Geneva Association (2010).

  44. For a fascinating exposition of short and long debt cycles, written by a practitioner and founder of the world’s largest hedge fund, see Dalio (2014).

  45. D’Hulster (2009).

  46. Ingves (2014, p. 1).

  47. Average of Apple, Exxon Mobil, Google, PetroChina, General Electric, Wal-Mart Stores, IBM, Microsoft, Nestlé and Chevron (Ingves, 2014).

  48. Common equity over total assets reached minimum levels of 1.64 per cent for some banks in Germany and Great Britain over the 2004–2011 period (see Kok and Schepens, 2013, Table 6).

  49. In the same vein, rating agencies measure the leverage of insurers by dividing their debt by their equity and by comparing their debt to their pre-tax earnings. See, for instance, Moody’s metrics of adjusted financial Leverage: adjusted debt (financial debt (including preferred stock)+Moody’s pension, hybrid, and operating lease adjustments) divided by (adjusted debt+shareholders’ equity) and earnings coverage: adjusted earnings before interest and taxes divided by interest expense and preferred dividends (five-year average). See Moody’s (2014).

  50. Systemic regulation should focus on reducing the impact of resolution, not the frequency of resolution. Any company that is not viable must be in a position to exit the market without causing turbulences (see The Geneva Association, 2012b).

  51. For an excellent overview, see Plantin and Rochet (2007).

  52. U.K. Equitable, for example, had to be wound down and has been in run-off for years. Policyholders are served from the asset pool just as if the insurance company were active.

  53. There is another fundamental point regarding the role of capital in prudential regulation. Policyholder protection can be enhanced through demanding more capital on top of calculated technical reserves, or by strengthening the demands on the calculation of reserves themselves. Continental European supervisors have traditionally focused their attention on the adequacy of technical reserves, which represent 90 per cent or more of liabilities, whereas U.K. or U.S. supervisors have focused more on capital. It is important to recall that the prime emphasis of insurance supervision should be on the adequacy of technical reserves or provisions themselves, less on equity capital, as the latter is merely an additional buffer in case reserves have been underestimated.

  54. IAIS (2013a).

  55. See Cœuré (2013).

  56. See for instance the description of these contracts made by the IFRS (2014)

  57. For a recent overview, see Eling and Pankoke (2012).

  58. De Bandt and Hartmann, 2000; Acharya et al., 2010.

  59. Billio et al. (2010).

  60. Adrian and Brunnermeier (2014).

  61. Bach and Nyuyen (2012); Rodriguez-Moreno and Pena (2013).

  62. Baur et al. (2003); Weiss and Mühlnickel (2012); Cummins and Weiss (2011, 2013); Chen et al. (2013).

  63. Zigrand (2014) provides an insightful and comprehensive analysis of systems in finance and economics.

  64. ECB (2010); Halaj and Kok (2013).

  65. Billio et al. (2012).

  66. In the last two equity market crises (2002–2003 and 2008–2009), the marking to market of assets (in IFRS and U.S.-GAAP), combined with the stress tests applied to insurers by regulators and supervisors in times of market distress, have had a procyclical effect in forcing insurers to sell holdings of equities to protect their solvency, whereas, in previous crises, they were more able to act as holder of long-term assets of last resort.

  67. Bisias et al. (2012).

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Acknowledgements

This paper has benefited from discussions with, and comments by, H. de Castries, D. Duverne, B. Zoellick, F. Hufeld, S. Lemery, O. de Bandt, D. Elliott, G. Harlin, R. Koijen, A. de Mailly Nesle, J.-D. Letoquart, F. Lorillon and A. de Montchalin, as well as seminar participants at the Paris School of Economics and the University of Munich. It has also benefited from research assistance by Q. Gisserot. Views expressed are those of the author.

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  1. AXA, 25 avenue de Matignon, 75008, Paris and Paris School of Economics, 48 boulevard Jourdan, 75014 Paris, France

    Christian Thimann

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Thimann, C. Systemic Features of Insurance and Banking, and the Role of Leverage, Capital and Loss Absorption. Geneva Pap Risk Insur Issues Pract 40, 359–384 (2015). https://doi.org/10.1057/gpp.2015.13

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