Swiss Re's CRO David Cole on systemic risk

Swiss Re's CRO David Cole on systemic risk

This year Swiss Re celebrates its 150th anniversary. In the coming months, we are planning various events, conferences and exhibitions across the globe to celebrate. Our focus for the year will not only be on Swiss Re’s long history, but also on the future. It will be a milestone year for Swiss Re, and one in which we can justifiably feel very proud.

However, 2013 has some challenges ahead. One of them is centred on the issue of importance. In April 2013, the FSB and IAIS are expected to announce a list of so-called global systemically important insurers (GSII’s).

The intention to create additional security for the global financial system is certainly admirable. However, we wonder whether this step is really necessary for the insurance industry. After all, the GSII designation is essentially an attempt to supervise global insurers along lines designed for the banking sector in the wake of the financial crisis.

We have concerns about the consequences, both intended and unintended, of this step. Swiss Re is already subject to intensive local and group supervision, advanced capital standards under the Swiss Solvency Test (SST) and an active College of Supervisors, which should duly be taken into account when assessing the Group and calibrating prudential measures.

There are concerns about important contradictions in the IAIS approach and the GSII methodology. We feel these undermine the policy makers’ and governing officials’ own aims of stability and economic growth. We are concerned that the IAIS is overly focused on the size and interconnectedness of insurance groups, and that this focus will undermine the benefits of risk pooling and diversification as well as limiting the way in which insurers invest their capital back into the economy.

But let’s start at the beginning: relevance. Are (re)insurers relevant to the global financial system? The answer, thankfully, is a resounding “yes”. Insurers are more than relevant. They are essential.

The insurance industry has been one of the great enablers of risk-taking and hence the development of the global economic system since at least the 17th century. In the modern financial system we fulfill the important function of absorbing risks and managing them through diversification and transferring a certain level of risk out of the sector. This allows entrepreneurial activity to take place at acceptable levels of risk. We are also important as a shock absorber, particularly of peak risk. This function goes back to the very founding of companies like Swiss Re and has continued unbroken to this day.

This fundamental relationship between insurance, innovation and development applies especially to emerging markets. In emerging markets insurance is essential for facilitating growth and business is coming to understand the role of an efficient and well-functioning insurance industry for enabling risk-taking.

When we talk about “systemic importance”, we must be clear in our terms. The debate is also about risk. At the centre of this debate is the key question: To what extent do (re)insurers add risk back into the system? The answer is: very little.

Various organisations, including the IAIS and G30, have already concluded that traditional (re)insurance activities are unlikely to pose systemic risk and that they are not amplifiers of systemic risk. In fact, as recently as July 2012, the IAIS found that the structure of the global (re)insurance industry was such that it served to “stifle the proliferation of shocks across the whole sector”.
However, because of a blurring of ideas between banking and insurance regulation, and no small measure of political pressure, insurers find themselves being measured by a similar yardstick to banks. We are experiencing a mismatch between regulation and the economic reality of our industry.

The financial crisis highlighted the need to avoid the turmoil and financial hardship caused by the dissolution of financial institutions. But the impact of insurers and banks going out of business is significantly different. For the banking sector, the danger of a large-scale meltdown based on a chain-reaction initiated by one well-connected global bank is very real.

For insurers there is a very different scenario. Far from being an indicator of the potential systemic risk of an organisation, increased size and global diversification are in fact healthy goals for (re)insurance groups to pursue. The spread of insurance business across multiple lines and geographies is beneficial to risk diversification.

Then there is the manner in which insurers go out of business. The failure of an insurer is a very different scenario from a bank failure. Insurers have reserves to cover in-force liabilities and future claims, even if they are unknown. Insurers don’t have a bank’s immediate liquidity calls — they are pre-funded by a stable flow of premiums which do not simply vanish. Insurers are also supported by long-term asset liability matching.

In other words, an insurer has time to leave the market in an orderly way, disposing of liabilities and assets over years. In our business there is “life after death.”

Then there is the issue of investment into the real economy. Regulators need to be aware that measures which are intended to limit the impact of a sudden exit of a large (re)insurance player may inadvertently limit insurers’ ability to supply capital to the economy. This will occur if insurers are required to lock up their capital for regulatory reasons, rather than being free to deploy long-term investment funds in the real economy.

Should this happen, one of the big losers will be governments themselves. There is a real danger that insurers will be less able to invest in areas such as infrastructure projects, which boost growth, drive up competitiveness and create jobs.

According to the OECD and Oliver Wyman, around USD 53 trillion will need to be invested in European infrastructure over the next 20 years — this is equivalent to three times the European Union’s GDP in that time. However, many European governments are highly indebted and simply do not have the money to provide this level of investment. The banking sector, which has been a significant provider of private financing for infrastructure projects, is now capital constrained and banks are no longer able to provide financing with maturities suitable to the long-dated nature of infrastructure.

Insurers and pension funds, on the other hand, are well-placed to fill the gap. However, there is already a mismatch between the regulatory environment and the role insurers need to play. For example, infrastructure investments are often punished from a regulatory standpoint because they lack liquidity and, despite their underlying security, they are treated as unsecured corporate credit. Rather than removing the barriers to free up much needed investment, the regulators appear to be adding more regulatory hurdles which make it even harder for insurers to fulfill a much needed role in society.

It is difficult to know exactly what the implications and effects of a GSII listing would be, but we do have some clues. The IAIS has developed three proposed policy measures for those companies that will be named GSIIs. These are aligned with FSB recommendations and include enhanced supervision, effective resolution, and higher loss absorbance capacity. The most controversial and critical issues are the proposed separation of non-traditional and non-insurance activities (NTNIA) and the application of capital surcharges. All these could undermine the important functions — namely, enabling risk-taking and pooling long-term investment — described above.

There are also other possible market implications for GSII listed companies. For example, will clients and investors view the GSII designation as a strength, or will it have no substantial meaning at all?

The current feeling in the industry is that supervisory bodies should focus on risk activities, not institutions. Prudential oversight at the macro level should identify activities with potential systemic risk; supervision at the micro level should address the specific institutions conducting or exposed to those activities. Concentrating only on institutions of a given size creates openings for risk migration, underestimation of systemic risk and market distortions. By trying to remove the “too-big-to-fail” risk, which has proven to be a very unlikely risk for core insurance activities, regulators are introducing the risk of moral hazard.

Whatever the consequences of the April GSII listing, 2013 will be a year where the insurance industry will continue to go about its business providing a home for risks and enabling global economic growth. In other words, we hope to continue to be relevant — listed or not.


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