New IAIS capital rules to hinder industry

The recent proposal by the International Association of Insurance Supervisors (IAIS) to apply additional risk-adjusted capital rules to major re/insurers is unnecessary and could have adverse consequences on the market.

That is the view of Stuart Shipperlee, analytical partner, Litmus Analysis, who says the IAIS seems to be “joining the regulatory bandwagon” by seeing these large re/insurers as a potential threat to the stability of the global financial system.
“Other than when they choose to act as ‘shadow banks’, the exact basis for why even the largest re/insurers should be considered to represent a systemic source of risk is debateable to say the least, particularly if that leads to a requirement for additional capital levels over and above those already considered prudent within existing and proposed insurance regulatory regimes such as Solvency II,” Shipperlee said.

“Extra capital can mean only one of two things; less re/insurance or more expensive re/insurance. The concept makes little sense in general, and particularly so for reinsurers.”

Shipperlee goes onto explain that the systemic risk in question derives from the ‘contagion’ or domino effect when the failure of one organisation triggers that of others. “This may be caused either by the consequences of ‘fear’ – leading to creditors demanding their money back and asset prices plunging – or by the knock on impact of bad-debts on the failed organisation’s creditors,” he said. “The former is the classical ‘run on a bank’ problem.”

Such a scenario does not translate into insurance, however. Although some savings or investment related life insurance products can contain an option for policyholders to demand an immediate pay-out, any liquidity risk would be specific to a single insurer.

“A systemic problem would only result if a significant number of life insurers had this as a major exposure and policyholders lost confidence in them collectively,” he said. “Even that is a lot more manageable than controlling the nature and consequences of a banking crisis.”

There are some scenarios that could cause a systemic risk, he admits. A large reinsurer failing could cause such a problem but the scale of its failure would need to be catastrophic to the extent it would be capable of paying so little of any given claim that the loss could trigger further failures.

A huge catastrophic event wiping out much of the reinsurance industry in one fell swoop is also a remote possibility. “But, again, that is a risk that really falls outside any reasonable application of regulatory capital rules,” Shipperlee said.

He suggests that a sounder prudential regulatory approach might be to simply prevent regular re/insurers trading credit protection products (shadow banking).

Alternatively, a ‘mark to market’ approach to valuing re/insurers’ invested assets (the near universal direction of travel in accounting and regulation) would bring stability to the system but this could also cause problems,” he said.

“Restricting, as it does, the ability of these otherwise natural ‘buy and hold’ investors to provide a rationale ‘pricing floor’ in traded financial assets during a crisis (which is when it actually matters) this could simply make things a great deal worse, to wit preventing those financially capable of ‘catching the falling knife’ from actually doing so,” he said.

“Indeed, were that to be addressed then, far from being a source of systemic risk, re/insurers could be a source of systemic risk mitigation.”