THE INSURANCE SECTOR TRENDS AND SYSTEMIC RISK IMPLICATIONS Based on - - PowerPoint PPT Presentation

THE INSURANCE SECTOR

TRENDS AND SYSTEMIC RISK IMPLICATIONS

Based on Global Financial Stability Report, IMF, April 2016

Nico Valckx

Workshop on Systemic Risk in Insurance Columbia Business School, October 28, 2016

Motivation and Main Findings

Motivation (1)

Relative Size of Financial Intermediaries

(Percent of GDP)

 Insurance sector:  Big player in financial markets  Important economic functions

50 100 150 200 250 300 350 400 450 2005 2015 2005 2015 2005 2015 2005 2015 2005 2015 2005 2015 United States Canada Euro area United Kingdom Japan Korea Insurance Banks OFIs Pension funds

• Two views on systemic risk

Individual insurers System of insurers Large complex interconnected Default, stop funding, stop lending, securities. Correlated sales, fire sales, stop/reduce funding. Distress? … … … Shock to asset prices

Counter- party stress … risks to real activity

Common exposures Domino View Tsunami View

Motivation (2)

Questions answered in GFSR

Has insurance sector’s systemic importance changed over time/countries? What explains changes in systemic importance?

• Investment

behavior

• Maturity

mismatches

• Business models
• Broader market

dynamics

Implications for insurance regulation?

• Increased, esp. life, but lower than banks
• More homogenous, higher commonalities
• Increased market risk and interest rate sensitivities

Systemic importance

• Insurers transmit shocks across financial system
• Especially in Europe and North America

Spillovers

• No major shift towards “riskier” assets
• But assets have become “riskier”
• Search for yield among weaker, smaller firms

Life insurers’ assets

• Macro-prudential approach needed
• International capital and transparency standards
• Focus on smaller and weaker firms

Regulatory implications

Main findings

Insurance Sector: Systemic Importance

Increased price comovement among insurers

Time series clustering

(Number of clusters)

Insurers’ Equity Return Due to First Principal Component (Percent)

20 40 60 80 100 I II I II I II I II I II Life Nonlife Life Nonlife Mixed United States Europe

Systemic Risk – rising CoVaR and capital shortfalls

CoVaR Indices (Normalized, 2006=100)

North America Europe Advanced Asia

Conditional capital shortfall (USD trillions)

0.0 0.5 1.0 1.5 2.0 2001 2004 2007 2010 2013 2016 Life insurers Nonlife insurers Banks 0.0 0.2 0.4 0.6 0.8 2001 2004 2007 2010 2013 2016 Life insurers Nonlife insurers Banks 0.0 0.4 0.8 1.2 2001 2004 2007 2010 2013 2016 Life insurers Nonlife insurers Banks

50 100 150 200 250 300 350 2006 2009 2012 2015 Banks Nonlife insurers Life insurers 50 100 150 200 250 300 350 2006 2009 2012 2015 Banks Nonlife insurers Life insurers 50 100 150 200 250 300 350 2006 2009 2012 2015 Banks Nonlife insurers Life insurers

2 4 6 8 10 12 14 16 18 20 Nov-01 Mar-07 Aug-08 Dec-14 Top 25 Top 50 Top 100

• 16
• 12
• 8
• 4

4 8 Nov-01 Mar-07 Aug-08 Dec-14 Top 25 Top 50 Top 100

A +10 percent value for the top 100 indicates that there are 10 percent more insurance firms among the top 100 than justified by their sample share.

Life insurers Non-life insurers Forward-Looking Default Correlation Networks (Percent; over- or underrepresentation of insurers)

Systemic Risk

Default Correlation Networks rank Life high

Systemic Risk Spillovers:

Insurance is shock transmitter

Systemic Importance Drivers

Investment behavior

• Take on greater asset risk in low interest rate environment?

Across asset categories true only for weaker, smaller firms

• Increased similarity in asset composition?

Not apparent

• Greater procyclicality in investment behavior?

Mixed evidence

• But greater common exposure to

aggregate risk interest rates

• 1. More risky investments: at lower cap, smaller firms and

those with more annuity/min.return products

• 4
• 2

2 4 6 High interest Low interest High interest Low interest High interest Low interest All United States Canada Netherlands Germany With low interest rates, the propensity of lower-capitalized firms to hold riskier assets is strengthened.

• 5

5 10 15 High interest Low interest High interest Low interest High interest Low interest Guaranteed interest United States Canada Netherlands Germany

With low interest rates, the propensity of firms with higher annuity product shares to hold riskier assets is strengthened.

Firms with higher guaranteed interest rates on life insurance offerings have larger risky asset portfolios.

• 15
• 10
• 5

5 10 15 High interest Low interest High interest Low interest All All All United States Canada Netherlands Germany Korea

With low interest rates, the propensity of smaller firms to hold riskier assets is strengthened.

1 2 3

In low interest environments, factors that contribute to higher exposure to riskier assets are lower-capitalization …. … a higher share of annuity products in total liabilities … … and the size of the firm , with smaller being more exposed

• 2. Procyclicality
• 3. Duration mismatches
• Mixed evidence
• Higher i-rate sensitivity

U.S. insurers acted countercyclically in 2008 and contributed to stability US and European Insurers' Equity Returns‘ Interest Rate Sensitivity Increases …and so does their net duration mismatch But… turnover at firm level did not increase in recent years

• 0.80
• 0.70
• 0.60
• 0.50
• 0.40
• 0.30
• 0.20
• 0.10

0.00 0.10 Life Nonlife Life Nonlife Mixed Life Nonlife U.S. insurers European insurers Asian insurers Precrisis Postcrisis

Note: For a negative (net) duration, insurers’ liabilities are longer than their assets. Insurers’ future business prospects get better (worse) when interest rates increase (fall).

• 4. Liability side developments

may also contribute to riskiness…

Life Insurers’ Unit-Linked Products (Percent of assets)

10 20 30 40 50 60 70 80 2004 2006 2008 2010 2012 2014

United States Netherlands Germany United Kingdom Korea Scandinavian countries Switzerland Canada

5 10 15 20 10 20 30 40 50 60 70 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015:H1 Catastrophe bonds Sidecars Industry loss warranties Collateralized re and other Share alternative capital (right scale) (Billions of U.S. dollars) (Percent)

Unit-linked products are a form of long-term insurance whereby the policyholder chooses the investment strategy. These products can, but do not necessarily have to, include guarantees.

Alternative Insurance Risk Capital Instruments

• 5. Changed Market Dynamics

Higher cross-asset correlations post-2010

• Search for yield
• Lower risk aversion

Temporary factors

Increase risk of market illiquidity Benchmarking more widespread

Structural changes

Greater similarity across insurance firms’ stock prices Insurance stocks more affected by common shocks

Implications for Regulation

Recent Regulatory Developments

• Regulations now more risk-based and

accounting principles more market-based

– valuations more market-sensitive – investment horizons of risky investments shortened – the maturity of safe assets extended

• Wide variations in capital requirements and

the use of internal models

– These are among the main problems in developing a global capital framework – But progress is being made

Compliance with ICPs

• 1. Selected IAIS Core Principles on Regulation
• 2. Selected IAIS Core Principles on Business Strategies

20 40 60 80 100 AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM Exit M&A

• Cond. Enforce. PCA

Report MaPru. Groups Observed Unobserved 20 40 60 80 100 AE EM AE EM AE EM AE EM AE EM AE EM AE EM Activity Invest. Liab. Risk Mgt. Cap. Gov. Disclose Observed Unobserved

Forward looking lessons for Regulation

• Macro-prudential approach

– address risks related to common exposures

• Market-consistent valuation standards

– enhance transparency – address duration mismatches

• Supervisory follow-up of smaller and weaker firms

– Focus should not be restricted to only large firms – Too-many-to-fail problem – Contagion

• Vigilance to avoid regulatory arbitrage