geneva association systemic risk in insurance report march2010

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Systemic Risk in InsuranceAn analysis of insurance and nancial stability

Special Report of The Geneva Association Systemic Risk Working Group

March2010


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The Geneva Association

(The International Associationfor the Study of Insurance Economics)

The Geneva Association is the leading international insurance think tank for strategically important insuranceand risk management issues.

The Geneva Association identies fundamental trends and strategic issues where insurance plays a substantial

role or which inuence the insurance sector. Through the development of research programmes, regular

publications and the organisation of international meetings, The Geneva Association serves as a catalyst for

progress in the understanding of risk and insurance matters and acts as an information creator and disseminator.

It is the leading voice of the largest insurance groups worldwide in the dialogue with international institutions.

In parallel, it advancesin economic and cultural termsthe development and application of risk management

and the understanding of uncertainty in the modern economy.

The Geneva Association membership comprises a statutory maximum of 80 Chief Executive Ofcers (CEOs)

from the worlds top (re)insurance companies. It organises international expert networks and manages discussionplatforms for senior insurance executives and specialists as well as policy-makers, regulators and multilateral

organisations. The Geneva Associations annual General Assembly is the most prestigious gathering of leading

insurance CEOs worldwide.

Established in 1973, The Geneva Association, ofcially the International Association for the Study of Insurance

Economics, is based in Geneva, Switzerland and is a non-prot organisation funded by its members.

President:Dr Nikolaus von Bomhard, Chairman of the Management Board, Munich Re Group, Munich.

Vice Presidents: Mr Michael Diekmann, Chairman of the Management Board, Allianz SE, Munich;

Mr Kunio Ishihara, Chairman of the Board, Tokio Marine & Nichido Fire Insurance Co., Tokyo;

Mr John Strangfeld, Chairman and CEO, Prudential Financial, Inc., Newark.

Members of the Board: Dr Carlo Acutis, Vice President, Vittoria Assicurazioni S.p.A., Turin;

Mr Antoine Bernheim, President, Assicurazioni Generali S.p.A., Trieste; Ms Christine Bosse, CEO, TrygVesta

Group, Ballerup; Mr Henri de Castries, Chairman of the Management Board and CEO, AXA Group, Paris;

Mr Patrickde Larragoiti Lucas, President, Sul America Seguros, Rio de Janeiro; Prof. Denis Kessler, Chairman

and CEO, SCOR, Paris; Dr Stefan Lippe, CEO, Swiss Re Group, Zurich; Mr Jos Manuel Martinez, Chairman,

MAPFRE SA, Madrid; Mr Andrew Moss, CEO, Aviva plc, London; Mr James J. Schiro, CEO, Zurich Financial

Services, Zurich; Mr Donald A. Stewart, CEO, Sun Life Financial Inc., Toronto; Mr PatrickThiele, President

and CEO, Partner Re Insurance Co., Pembroke; Mr Mark Tucker, Group Chief Executive, Prudential plc,

London; Dr Richard Ward, CEO, Lloyds, London.

Secretary General and Managing Director:Mr Patrick M. Liedtke (Head of Insurance and Finance), Geneva.

Vice Secretaries General: Prof. Jan Monkiewicz (Head of Progresand LiaisonEastern Europe), Warsaw;Mr WalterStahel (Risk Management), Geneva.

Heads of Research Programmes: Dr Christophe Courbage (Health & Ageing and Insurance Economics)

Geneva; Ms Genevive Reday-Mulvey (Four Pillars) Geneva.

Head of Communications:Mr Anthony Kennaway,Geneva.

Special Ofcers: Mr Katsuo Matsushita (LiaisonJapan & East Asia), Yokohama; Dr Bruno Porro (Chairman

of Chief Risk Ofcers Network), Zurich; Mr Gordon Stewart, (LiaisonEastern North America), New York.

Chairman of the Scientic Advisory Council:Prof. Harold Skipper, Georgia State University, Atlanta.

Former Presidents of The Geneva Association:Mr Raymond Barre, Paris (1973-1976); Mr Fabio Padoa,

Trieste (1976-1983); Mr Julius Neave, London (1983-1986); Prof. Dr Dr e.h. ReimerSchmidt, Aachen (1986-

1990); Sir Brian Corby, London (1990-1993); Drs. Jan H. Holsboer, Amsterdam (1993-1999); Mr WalterKielholz, Zurich (1999-2003); Mr Henri de Castries, Paris (2003-2008); Mr Martin J. Sullivan, New York

(2008); Mr Jacques Aigrain, Zurich (2008-2009).


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Special Report of The Geneva Association Systemic Risk Working Group


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53 Route de Malagnou,

CH-1208 Geneva,

SwitzerlandE-mail: [email protected]

Tel: +41-22-707 66 00

Fax: +41-22-736 75 36

www.genevaassociation.org

March 2010



Published by The Geneva Association (The International Association for the Study of InsuranceEconomics)


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Contents

Foreword 1

Executivesummary 3

0. Introduction 5

0.1.Purposeofthisreport 5

0.2.Reportstructure 5

0.3.Theeconomicandsocialroleofinsurers 5

0.3.1.Providingprotectionforindividualsandtheirpossessions 6

0.3.2.Financingtheeconomythroughthepremiumsraised 6

0.4.Theimportanceofinsuranceinnumbers 7

0.5.Thedifferenttypesofinsurersbusinessmodels 8

1. Settingthescene 11

1.1.Thenancialcrisis:thedifferenteffectsonbanksandinsurers 11 1.1.1.Insurersvs.banks:capitalandcapacity 12

1.1.2.Insurersvs.banks:stablevolumeandpricing 13

1.2.Theeffectsofthecrisisontheinsuranceindustry 15

1.2.1.Insurerswithlimitedbankingactivities 15

1.2.2.Bank-insuranceconglomerates 16

1.2.3.Insurerswithwholesalebankingoperations:AIG 17

1.2.4.Monoliners 18

1.2.5.Conclusion 20

1.3.Whydidinsurersfarebetter? 20

1.4.Conclusion 22

2. FSBandIAISdenitionofsystemicrisk 23

2.1.Size 24

2.2.Interconnectedness 25

2.3.Substitutability 26

2.4.Timing 28

2.5.Contributingfactorstotheassessmentofsystemicimportance 29

2.6.Wind-upandrun-off:insuranceindustryexperience 29

2.7.ConclusionontheFSBandIAIScriteriaforsystemicrisk 31

3. Assessingsystemicrelevanceofinsurersriskactivities 33

3.1.Investmentmanagementactivities 35 3.1.1.Assetliabilitymanagementandstrategicassetallocation 35


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3.1.1.1.Exposurestoothernancialinstitutions 36

3.1.1.2.Investmentinequities 37

3.1.1.3.Investmentincallablebonds 38

3.1.1.4.Programmetrading 39

3.1.2.Derivativesactivitiesonnon-insurancebalancesheets 40

3.2.Liabilityoriginationactivities 40

3.2.1.Underwritingcatastrophicrisks 41

3.2.2.Underwritinglong-termrisks 44

3.2.3.Writingbusinesswithredemptionoptions 46

3.2.4.Writinglifeinsurancewithembeddedguarantees 48

3.3.Risktransferactivities 49

3.3.1.Hedgingwithderivatives 49

3.3.2.Reinsuranceandretrocession 50

3.3.3.Insurancelinkedsecuritiesandinsurancederivatives 53

3.4.Capital,fundingandliquiditymanagementactivities 55

3.4.1.Mis-managementofshort-termfundingraisedthroughcommercial

paperorsecuritieslending 55 3.4.2.Raisingdebtorequitycapital 58

3.5.Creditprotectionactivities 58

3.5.1.Creditinsurance 58

3.5.2.Financialguarantees 59

3.5.3.CDSwriting 61

3.6.Conclusion 63

4. TheImpactofregulatoryregimesonidentiedsystemicriskissues 65

4.1.Introduction 65

4.2.Assessmentofsystemicallyrelevantriskactivitiesunder

theEuropeanandU.S.regulatoryregimes 66

4.2.1.Derivativesactivityonnon-insurancebalancesheets 66

4.2.1.1.AssessmentofEuropeaninsuranceregulation 66

4.2.1.2.AssessmentofU.S.insuranceregulation 67

4.2.2.Mis-managementofshort-termfundingraisedthrough

commercialpapersorsecuritieslending 67

4.2.2.1.AssessmentofEuropeaninsuranceregulation 67

4.2.2.2.AssessmentofU.S.insuranceregulation 68

4.3.Internationalregulatoryinitiatives 68

5. Mitigatingmeasures 71

5.1.Principlesofselectingamitigatingmeasure 71

5.2.Mitigatingmeasurestargetedtospecicidentiedissues 72

5.2.1.Measure1:Implementcomprehensive,integrated

andprinciple-basedsupervisionofinsurancegroups 72

5.2.2.Measure2:Strengthenliquidityriskmanagement 73

5.3.Additionalmeasurespromotingnancialstability 74

5.3.1.Measure3:Enhanceregulationofnancialguaranteeinsurance 74

5.3.2.Measure4:Establishmacro-prudentialmonitoring

withadequateinsurancerepresentation 74

5.3.3.Measure5:Strengthenriskmanagementpractices 75


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AppendixA.Timelineofthecrisis 77

AppendixB.Casestudiesoftroubledinsurers 87

B.1.AIG 87

B.2.ING 90

B.3.TheHartford 91

AppendixC.Sizeanddiversicationofinsurers 93

C.1.Sizeoftop10Europeaninsurersandbanks 93

C.2.Sizeoftop10NorthAmericaninsurersandbanks 94

C.3.DiversicationofEuropeaninsurers 95

AppendixD.Insurerwind-ups:EquitableLifeandHIH 97

D.1.Casestudy:thefailureofEquitableLifeAssuranceSocietyintheU.K. 97

D.2.Casestudy:thefailureofHIHInsuranceinAustralia 99

AppendixE.EUinsuranceregulation:SolvencyII 103

AppendixF.U.S.insuranceregulationwithfocusonRBC 105AppendixG.Swissinsuranceregulation:theSwissSolvencyTest(SST) 107

AppendixH.SolvencyIIandBaselII:acomparisonofcriticalaspects 109

References 111

Glossary 113

Exhibits

Exhibit1:Breakdownofinsurancepremiumsbylineofbusinessandgeography 7

Exhibit2:Premiumspercapitainlifeandnon-lifeinsurance(inUSD,2008) 8

Exhibit3:Chronologyofthecrisismarketdevelopments2007-2009 11Exhibit4:U.S.nancialstressindex2007-2009 12

Exhibit5:Re-capitalisationandcreditlosses 13

Exhibit6:Riseandfallofwholesalefundingandinterbanklending 13

Exhibit7:Borrowingratesduringthecrisis 14

Exhibit8:Insurancepricingduringthecrisis 14

Exhibit9:Crisisimpactbyexposuretobankinginoperations 15

Exhibit10:Insurancecompaniesaffectedduringthecrisis 16

Exhibit11:AIGrevenuesbydivision 17

Exhibit12:Monolinersexposuresduringthecrisis 19

Exhibit13:Monolinerscorrelationtothehousingmarkets 19

Exhibit14:Insurerscash-owsbysource 20Exhibit15:Operatingnetcash-owsandinvestmentsbymajorEuropeaninsurers 21

Exhibit16:Estimatedcashcoverageofinsurancecompanies 21

Exhibit17:Insurancedebtissuanceduringthecrisis 22

Exhibit18:Denitionsofsystemicriskandsystemicrelevance 23

Exhibit19:Economiccapitalbyrisksource 24

Exhibit20:Interconnectedness:insurancevs.banking 25

Exhibit21:Worldwidereinsurancecapitalinows1990-2008 27

Exhibit22:ConcentrationofEuropeanprimaryinsurancemarkets 27

Exhibit23:ConcentrationoftheglobalandU.S.reinsurancemarkets 28

Exhibit24:TimingofWorldTradeCentreclaimspayments 28

Exhibit25:Approachforassessingsystemicrelevance 33

Exhibit26:Universeofactivitycategoriescarriedoutbyinsurancecompanies 34


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Exhibit27:Inter-connectionsofkeyriskactivitiesinwhichinsurerscanengage 35

Exhibit28:Insurersassetsaresignicantlylowerthanbanksassets

andcapitalmarketsassets 36

Exhibit29:Insurersexposuretoothernancialinstitutions 37

Exhibit30:Insurersandtheequitymarkets 37

Exhibit31:Illustrationofconvexitymismatch 38

Exhibit32:ExampleofimpactofprogrammetradingDutchpensionfundhedge

oneurolong-termswaprates(December2008) 39

Exhibit33:Catastrophelossesvs.bankfailures 41

Exhibit34:Catastrophelosscoverage 42

Exhibit35:Timingofinsuranceclaimsettlementexampleofmedicalliability

andWorldTradeCentre 43

Exhibit36:Illustrativeexample:riskofjumpinlongevity(U.K.) 45

Exhibit37:Casestudyonasbestosis 45

Exhibit38:EffectofnancialcrisisonGermanlifelapserates 47

Exhibit39:Allianzsurrendersandnancialresources(2008) 47

Exhibit40:Illustrationofreinsurancespiral 51Exhibit41:Comparisonofinsurance,reinsuranceandretrocessiongross

writtenpremiumvolumes 52

Exhibit42:Cessionandretrocessionratesformajorprimaryinsurersandreinsurers 52

Exhibit43:ILSmarketgrowthandinsurersexposuretoILS 54

Exhibit44:Evolutionofweatherderivatives 54

Exhibit45:Liquidityriskfromstocklendingandcommercialpaperfunding 56

Exhibit46:LossesavertedbybailoutofAIGssecuritieslendingoperations 56

Exhibit47:Coverageofshort-termliabilitiesbyoperationalcash-ows

andliquidassets 57

Exhibit48:Overviewofcreditinsurancemarket 59

Exhibit49:Size,substitutabilityandinterconnectednessofmonoliners 60Exhibit50:AIGinvolvementinCDSanditsinterconnectednesstomajorbanks 61

Exhibit51:ExampleofdisconnectionbetweenCDSnotionalsandunderlyingdebt 62

Exhibit52:CDSsellersandbuyersbysector(December2006) 62

Exhibit53:AIGrevenues2005bybusinesslines 87

Exhibit54:Sizeoftop10Europeaninsurerscomparedtotop10banks 93

Exhibit55:Sizeoftop10NorthAmericaninsurerscomparedtotop10banks 94

Exhibit56:RelativepremiumcontributionsbyEuropeancountriesforEuropean

topinsurers 95

Exhibit57:EquitableLifelapserates2000-2004 98

Exhibit58:U.K.andEuroareaGDPgrowthratesandU.K.pensionerincome 99

Exhibit59:NationalAustralianeconomyanddwellingmarket 100Exhibit60:PillarstructureofSolvencyII 103

Acknowledgements

ThisGenevaReportis theproductofa collectiveexercisecomprisinga steeringcommittee,several

working groups and many individual efforts that drafted and discussed all the texts plus a series of

commentsfromoutsideexpertsandexternalsupportfromOliverWymanallundertheauspicesofThe

GenevaAssociation.

ItispartofalargereffortbyTheGenevaAssociationtostimulateandtoconductworkonthecredit

crisis,newregulatoryinitiativesandtheirimpactoninsurance.


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Steering Committee Members

Aegon:PatriciaPlas

Allianz:VolkerDeville

Aviva:JimWebber

AXA:BenotClaveranne Met Life:StanTalbi

Munich Re:JoOechslin

Swiss Re:RajSingh

The Geneva Association:PatrickM.Liedtke

Zurich Financial Services: AxelP.Lehmann

Working Group Members

Aegon:ChristianPierotti,PatriciaPlas

Allianz:MichaelButtstedt,ArneHolzhausen

Aviva:HughFrancis,TimHall,NickKitching,

AXA:BenotClaveranne,FabriceLorillon

Generali:GianfrancoVecchiet

Lloyds:AlastairEvans,GavinSteele

MAPFRE:LuigiLubelli

Met Life:LoriEvangel,SusanGreenwell

Munich Re:MatthiasKubicek,MichaelMenhart

Partner Re:FranoisVilnet

Prudential plc: MilesCelic,SvenKasper, PauletteKing,SallyPadget

Prudential Financial:ElisaPuzzuoli

SCOR:PhilippeTrainar

Sul America Seguros:OswaldoMario

Sun Life Financial: ClaudeAccum Swiss Re:PhilippeBrahin,AstridFrey,ThomasHess, KarenHudson

The Geneva Association:PatrickM.Liedtke,JanMonkiewicz

Tokio Marine:MakotoHori,MasaakiNagamura

TrygVesta:MartinBgeMikkelsen

Vittoria Assicurazioni:AndreaAcutis

Zurich Financial Services:PeterBuomberger,DanielHofmann,RoySuter

TheGenevaAssociationthanksOliverWymanfortheexternalsupport.

External Support

Oliver Wyman:AlexandreCarrion,ClaudiaFell,BernhardKotanko,AndrewRear


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Foreword

BasedonthetargetsputforwardbytheG20,preliminaryconsiderationsweregivenin2009

tointroducingmacro-prudentialsupervision.Thediscussionhingesonthe questionofwhether

and towhat extent systemic risksexistand how theseriskscan beaddressed bysupervisory

regulations.

Followingthere-establishmentoftheFinancialStabilityForumastheFinancialStabilityBoard

inApril2009,thediscussiontookonanewintensity.InOctober2009,theFSBincooperation

withtheIMFandtheBISpublishedareportonsystemicrisksthatincludedconcretedenitions

andadescriptionofrstregulatoryapproaches.TheninJanuary2010,theJointForumpublished

areportaddressingkeyissuesandcontainingconcreterecommendationswithregardtonancial

marketregulation.Withrespectto(re)insurance,theIAIShasofcoursealsoplayedasignicant

roleforsometimeonsystemicrisks.

Inthepast,therewasnoperceivedneedtospecicallyaddresssystemicriskininsurancebut,

givenrecentdevelopments,itwashightimefortheinsuranceindustrytoengageinthedebateon

systemicrisksandthewaytheyarehandledintermsofregulationandsupervision.The present report is devoted tothis task. The GenevaAssociation, numbering almost 80

CEOsfromtheworldslargestinsuranceandreinsuranceundertakingsamongitsmembers,has

withthehelpofindividualmemberstakenupthechallengeofstructuringandmoreaccurately

presentingkeyaspectsofthediscussionsurroundingthetopicofsystemicrisksintheinsurance

industry.

This appears to be necessary as in the public debate the business model ofthe insurance

industryisunfortunatelynotalwayssufcientlydemarcatedfromthebusinessmodelofother

nancialservicesproviders,suchasthebanks.Thewaysystemicrisksaretreatedmust,however,

take account of precisely these specic characteristics of the business models and particular

activitiescarriedoutbyinstitutions.

Thisreportisdesignedtoenrichtheongoingdiscussionalthoughitisclearthatthedebateon

systemicriskswillnotendwiththepublicationofthisreport.

Itisimportanttometopayrecognitiontotheprofessionalworkofthosewhohavecontributed

tothisreport.Thecompletionofthisrstcomprehensivereportonsystemicrisksintheinsurance

industrywithinsuchashorttimeisaremarkableachievement,forwhichIwouldliketothankthe

authorsandcontributorsonbehalfofallGenevaAssociationmembers.

DrNikolausvonBomhard

President of The Geneva Association

Chairman of the Board of Management, Munich Re Group


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3

Thenancialcrisishasexposedawsinthesupervisorysystemandengenderedcallstofurther

regulatethenancialsector.Amongthemanyproposalsunderconsiderationorimplementation

is the idea of applyingmore stringent supervisionand, perhaps, more onerous regulations to

systemically relevant institutions. This proposal is usually conceived as applying to banks.However,someinstitutionsandgovernmentshaverecentlysuggestedthatasimilarapproachbe

takentoinsurers.Thisreportexaminestheperformanceoftheinsuranceindustryduringthecrisis,

assessestheapplicationoftheFSBsproposalonsystemicrisktoinsurance,anddevelopsinitial

recommendationsto addresscurrentregulatory gapsandstrengthenindustry riskmanagement

practices.

Banksandinsurersplayedmarkedlydifferentrolesinthenancialcrisis:notonlywere

banks,notinsurers, thesourceofthe crisis, bankswere also muchharderhitbyit. Excluding

thoseinsurerswithlargequasi-bankingoperations,insurersreceivedlessthanUSD10billionin

directStatesupportduringthecrisis,comparedwithoverUSD1trilliongiventobanks.

Theinsurancebusinessmodelencompassing bothinsurers and reinsurershasspecicfeaturesthatmakeitasourceofstabilityinthenancialsystem.Insuranceisfundedbyup-

frontpremiums,givinginsurersstrongoperatingcash-owwithoutrequiringwholesalefunding.

Insurancepoliciesaregenerallylong-term,withcontrolledoutows,enablinginsurerstoactas

stabiliserstothenancialsystem.Duringthecrisis,insurersmaintainedrelativelysteadycapacity,

businessvolumesandprices.

Thosefewinsurerswhoexperiencedseriousdifculties,mostnotablyAIG,werebrought

downnotbytheirinsurancebusinessbutbytheirquasi-bankingactivities.Similarly,the

troubled monoliners (FSA, AMBAC, MBIA et al.) concentrated exclusively on nancial

guaranteesandCDSwritingandtrading.Morethan90percentofStatesupporttoinsurerswent

tothosewithsignicant,failingnon-insurancebusinesses.

TheFSB,BISandtheIMFrecentlygavetheirdenitionofsystemicrisk,whichwassupported

bytheG20nanceministersandcentralbankgovernors.AlthoughtheFSBdenitionisonlyone

amongmanyputforwardinrecentmonths,itisthemostcommonlycitedandprovidesastarting

pointforthepurposesofthisreport.

TheFSBusesthreecriteriatoassessthesystemicriskpresentedbyaninstitution:size,

interconnectednessandsubstitutability.TheIAIShasaddedtimethatis,thespeedofloss

transmissiontothirdpartiesasafourthcriterion.Thisisofparticularrelevancetoinsurance,as

insuranceclaims,unlikebankingobligations,donotimmediatelygeneratecashoutows.

Wedonotdisputethesecriteriaforsystemicrisk. Evenmoreimportantlyfortheregulatory

purposes,theyshowhowsystemicriskaccrues,nottorms,buttospecic activities ofthose

rms.

Executive summary


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ApplyingtheFSBcriteriatothemainactivitiesofinsurersandreinsurers,weconclude

that nonepose a systemic risk. These activities include investment management (investing

policyandshareholdersfunds),liabilityorigination(providingprotectionandguarantees),risk

transfer(throughreinsurance,securitisation,etc.),andcapitalmanagement.

Noneofthesepassthetestforsystemicrelevance,foratleastoneofthefollowingreasons: theirlimitedsizemeansthattherewouldnotbedisruptiveeffectsonnancialmarkets;

theslowspeedoftheirimpactallowsinsurerstoabsorbthem,suchascapitalraisingover

timeor,inaworstcase,engaginginanorderlywind-up;

featuresoftheirinterconnectednessmeanthatcontagionriskwouldbelimited.

Wendthatonlytwo,non-core activitiesofinsurerscouldhavethepotentialforsystemic

relevance, assuming that they are conducted on a huge scale and using poor risk control

frameworks:

derivativestradingonnon-insurancebalancesheets;

mis-managementofshort-termfundingfromcommercialpaperorsecuritieslending.

Currentandalreadyapprovedinsuranceregulatoryregimes ,suchasSolvencyIIinthe

EuropeanUnion,adequatelyaddressinsuranceactivities.Theremainingquestioniswhether

existingregulationadequatelymitigatespotentialsystemicriskfromthesenon-coreactivitiesor

whetheritneedssupplementingorreplacingwithnewmeasures.

We conclude that principle-based group supervision applied to all entities within

an insurance group (regulated and non-regulated), supported by sound industry risk-

managementpractices,willmitigatepotentialsystemicriskrelatedtotheseactivities.

SolvencyIIrepresentssuchacomprehensiveandeconomicbasedregulatoryframeworkthat

itshouldnotbeconfusedwithBaselII,despitenumericalequivalence.

Wealsobelievethatinsolvenciesneednotbeavoidedatanyprice. Facedwithaverylargeevent,aninsurercanfail;but,incontrasttowhatwehavewitnessedinthebankingsector,winding-

upaninsurerisanorderlyprocessthatdoesnotgeneratesystemicrisk. Webelievecross-

bordercrisismanagementremainsanarearequiringimprovedcoordinationamongsupervisors.

Inseekingtocloseremaininggapsinthesupervisoryframework,regulatorsshouldavoid

thetemptationtoplacespecialburdensonspecicinstitutions. Thisapproachcoulddistortthe

insurancemarketbyskewingpricing,reducingaggregatemarketrisk-bearingcapacity,drawing

supervisorsattentionawayfromriskyactivitiesgoingonelsewhere,andcreatingmoralhazard

inthesetoobigtofailinstitutions.Theconsequencesofgettingsystemicriskreformswrong

wouldnotonlybeseverelydamagingtotheinsuranceindustrybuttotheeconomyaswell.

Werecommendvemeasures.Thersttwoareputforwardtoaddressgapsinregulation

andindustrypracticeidentiedinthisreport;measuresthreetoveaim tostrengthennancialstability:

1. Implement comprehensive, integrated and principle-based supervision for insurance

groups.

2. Strengthen liquidity risk management.

3. Enhance regulation of nancial guarantee insurance.

4. Establish macro-prudential monitoring with appropriate insurance representation.

5. Strengthen risk management practices.

These measures demonstrate the industry engagement to contribute to the discussion on

systemicrisk.Theindustrystandsreadytotakeanyactionnecessarytomaintainstabilityinthe

insurancesystemitself,contributetothestabilityoftheoverallnancialsystem,andperformitsenablingroleintherealeconomy.


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0. Introduction

0.1. Purpose of this report

Thenancialcrisishasengenderedwidespreadcallsto furtherregulatethenancialsector.

Among the many proposals under consideration or implementation is the idea of applyingmore stringent supervision and, perhaps, more onerous regulations to systemically relevant

institutions.Thisproposalisusuallyconceivedasapplyingtobanks.However,someinstitutions

andgovernmentshaverecentlysuggestedthatasimilarapproachcouldbetakentoinsurers.

Thisreportexaminesthisproposal.

Unless stated otherwise, the term insurance is held to mean both primary and

reinsurance.Fortheavoidanceofdoubt,thenancialguarantorsknownasmonoliners

areexcludedfromthismeaning.

0.2. Report structure

Inthischapterwegiveabriefintroductiontotheinsuranceindustry,itseconomicroleandits

mainbusinessmodels.InChapter1weexaminethedifferentrolesplayedbybanksandinsurers

intherecentnancialcrisis,whichhasgenerallyhitinsurersfarlesshardthanbanks.

Chapter2considerstheFSBsproposedcriteriafordesignatinganinstitutionassystemically

relevant. We conclude that, in the rst instance, it is not insurance institutions but insurance

activitiesthatshouldbeconsideredinrelationtosystemicrisk.

Chapter3isdevotedtoexaminingthemainriskactivitiesofinsurersinlightoftheFSBcriteria.

Weconcludethatthesecriteriaexplainwhymostinsurersactivitiesdonotposeasystemicrisk

likesomebankingactivitiesdo.

Havingidentiedtwoactivitiesthatcanpotentiallyaddtoasystemicriskscenario,Chapter4considerstheextenttowhichtheyarealreadyadequatelydealtwithbyexistingregulations.

Finally,inChapter5,wesuggestmeansforclosingthegapsincurrentregulationsandpropose

waysofimprovingourownpractices.

0.3. The economic and social role of insurers

Insurers main functionsthe functions of insuranceare the provision of protection by

acceptingrisksfrompolicy-holders,poolingtheserisks,managingthemactivelyandpotentially

transferringtheminparttoreinsurers.

Duetotheirroleandthelong-termhorizonofmanyinsurancecontracts,insurershavelarge

amountsofinvestmentsundertheirmanagementtobackfutureclaimsandarethereforesignicant

players,withothernancialinstitutions,innancialintermediationandcapitalaccumulation.


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0.3.1. Providing protection for individuals and their possessions

Insuranceprovidesamechanismforthepoolingandtransferofthenancialconsequences

ofrisk.Inexchangeforapremium,theinsurercommitstonanciallycompensatingthepolicy-

holderforexpectedlossesresultingfromthecontract,operatingexpensesandcapitalcosts.

Insuranceactivitiesarebroadlydividedintolifeandnon-lifeinsurance.Lifeinsuranceprotects

againstthelossoffamilyincomeduetodisabilityordeathoragainsttheriskofoutlivingyour

nancial resources. Non-life insurance contracts provide protection against damage, loss, or

injurytotheinsured,aswellaslegalliabilityfordamagescausedtootherpeopleortheirproperty.

Reinsurersprovideprotectiontoinsurersthemselves.

Therecoursetoinsuranceallowspeopleandbusinessestoengageinactivitiesthatotherwise

wouldbetoofraughtwiththeriskoflosses.Theabsenceofinsurancewouldcontributetorisk

aversion and dampen the entrepreneurial spirit and many business initiatives would not be

undertaken.Withoutinsurance,noonecouldaffordtotaketherisksnecessarytogrowahealthy

economy.

Insuranceisalsoamajorcontributortoeconomicwelfareandfairnessandanessentialproviderofsocialprotection:

Contractual savings, particularly life insurance and pension, play an essential role in

providinglong-termnancialsecurityandgrowth,inparticularincountrieswherethisrole

isnotcoveredbytheState.

Non-lifeinsurancehelpsindividuals andrm hedge against importantrisksaccidents,

property,re,interruptionofproductiveactivity,generalandprofessionalliability,motor

thusallowingthemtoengageinseveraleconomicactivitiesandexpandtheproduction

frontier.

Becausetheyassumerisks,insurerspayparticularattentiontomanagingtheserisks,including

transferringthemtoreinsurers.Insurersalsoinvestgreatlyinhelpingtheirpolicy-holdersmanageandmitigatetheirownrisks.Therisksinsurerstakeonarediverse,andinsurersconstantlylook

fornewareasinwhichtheymayacceptasinsurablesomeoftherisksfacedbyotheractorsinthe

economy.

Insurersarenottheonlyentitiestoacceptrisksbanksalsoacceptrisks.Howevertheirrisks

arefundamentallydifferentfrominsurancerisks.Insuranceriskisidiosyncraticand,forthemost

part,independentof theeconomiccycle. Byacceptingshort-term,liquiddemanddepositsand

grantinglong-termloans,banksassumetwomajorrisks:creditriskrelatedtolendingactivities

andliquidityriskduetothemismatcharisingfromborrowingshortandlendinglong.Thesebank-

specicriskstendtobecorrelatedwiththeeconomiccycle.

0.3.2. Financing the economy through the premiums raised

For life insurance and many lines of non-life insurance, claims payments occur many

years after premiums have been collected. Consequently insurers have stable asset

portfolios to manage with a long-term horizon. Their investment activities in equities

and bonds provide a key link in capital markets, supporting the market place for savers

andborrowers.

Insurance therefore plays a key role in nancial intermediation by re-investing long-term

savingsthroughdebtandequityholdings.Insurersfundingprolesanddiversecustomerbases

allowthemtotakealong-termassetallocation,whichiskeyfornancingenterpriseswithlong-

termcapital.


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7

Insurersseeinvestmentriskdifferentlyfromassetmanagersasaninsurancecompanycannot

ignoretheliabilitysideofitsbalancesheet.Atypicalassetmanagerinvestsonbehalfofclients

andisfocusedonmaximisingthevalueofinvestmentsrelativetoaprescribedbenchmark.But

ininsurance,theinvestmentfunctionmustnotonlyachieveadequatereturns,itmustmanagethe

potentialmismatchinassetsandliabilitiesasaresultofchangesincapitalmarketconditions.

0.4. The importance of insurance in numbers

The importance of insurance is reected in the volume of premiums generated and

assetsmanaged.

WorldwideinsurancepremiumsamounttoUSD4.4trillion,whichrepresents7.3percent

ofworldwideGDP.Theexhibitbelowshowsthesplitofinsurancepremiumsbygeographyand

betweenlifeandnon-life.

Exhibit 1: Breakdown of insurance premiums by line of business and geography

Premium volume by business segment

USD BN, 2008

Source: Swiss Re sigma, IAIS Global Reinsurance Market Report 2009

1. Gross reinsurance premiums shown by region of ceding insurer

159

Europe

1,703(40%)

North America

1,344(32%)

59 66 1618

739

996

707

625

719

273

76

83

Asia Pacific

1,012(23%)

ROW

159(4%)

1,782(42%)

2,43658%

Non-life

insurance

Lifeinsurance

Reinsurance1

InsurershaveUSD18.7trillionofassetsundermanagement,1whichisroughly11percentof

theworldstotalnancialassets.

Insurancepenetrationishighlycorrelatedwiththelevelofdevelopmentofcountries.OECD

countriesachieveveryhighpenetrationlevelswithpremiumspercapitalforbothlifeandnon-life

ofaroundUSD3,000percapita(2008),asopposedtolessthanUSD500indevelopingcountries.

1. International Financial Services London Research, October 2009.

Introduction


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8


Exhibit 2: Premiums per capita in life and non-life insurance (in USD, 2008)

1,856

2,022

2,448

2,133

1,187725

220107811917

79692947380

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

North

America

Western

Europe

Japan &

industr.

As iancountries

Central and

Eastern

Europe

Latin

America and

Caribbean

Middle East

and Central

As ia

South and

East Asia

Af rica

Life Non-Life

Source: Swiss Re Facts and Figures 2008

0.5. The different types of insurers business models

Insuranceactivitiesarecarriedoutbydifferenttypesofplayers.Theseare:

purelifeinsurers;

purenon-lifeinsurers(Property&CasualtyInsurers);

compositeinsurers(mixoflifeandnon-lifeinsurers); reinsurers;

insurerswithlargenon-insuranceoperations;

monoliners/nancialguarantee.

Life insurance and non-life insurance must be provided in different legal entities; this is

understoodtohavebecomeageneralrequirementinallregulatoryjurisdictionsoutofadesireto

protectlifeinsuranceinvestments(heldonbehalfofsavers)fromadefaultinanon-lifeinsurance

companyofthesamegroup.Many,butbynomeansall,ofthelargeglobalinsurers,arecomposite,

offeringbothlifeandnon-lifepoliciestomakebestuseoftheirdistributionnetworkandcustomer

reach.Thelifeandnon-lifeinsurancebusinessescontinuetobeseparatelegalentities.Allinsurers

carryoutsomeformofinvestmentmanagementactivity.Variouspartsoftheinvestmentactivitymaybeoutsourced,butthecriticalresponsibilityforappropriatemanagementofasset-liability

matchingremainswiththeinsurerinanycase.

Reinsurers are insurers for insurers, allowing insurers to reduce their exposure to peak

lossesandconcentration.Overthelast150years,reinsurancehasevolvedasaneffectivemeans

ofcopingwiththegrowingnumberandincreasinglycomplexnatureofrisks,representingan

essentialproviderofriskdiversicationonaglobalbasisandstabilisingfactorfortheinsurance

system,andthusthewidereconomy.

Morerecently,someinsurershavemovedintoareasofothernancialservicestovarying

degrees:

Certaininsurancegroupscontainabankalongsidetheirinsurancesubsidiariesandutilisetheopportunitiestocross-sell.Thistakesthecommondistributionmodelofbancassurance

(retailinginsuranceproductsthroughanagreementwithabank)onestepfurther.


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9

Moreover,inlinewithnancialinnovation,insurershavebecomeinvolvedinderivative

activities.Certaininsurershavegonebeyondusingtheseinstrumentsforhedgingtheirown

investmentsandsetupdedicatedsubsidiariestransactingincomplexderivativeinstruments.

Finally, certain groups have developed into nancial conglomerates with substantial

bankingandderivativetradingactivities.We discuss the impact of the banking crisis on the banking subsidiaries of insurers in

Chapter1.

Monolinershaveadifferentbusinessmodelfromotherinsurers.Monolinerssellonly,inone

formoranother,nancialguaranteesforinvestorsonanancialinstrument.Thesedifferencesin

businessmodelcametotheforeintherecentcrisisasmonolinersriskprolesweresimilartothat

ofabank,duetothepredominanceofcreditrisk.InChapter5weputforwardourviewthatthe

regulationofmonolinersshouldbeconsistentwiththatofbankscarryingoutthesameactivity.

Introduction


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10



21/129

11

Webegininthischapterbydescribingthedifferentrolesofbanksandinsurancermsinthe

nancialcrisis,anditsdifferenteffectsonthem.Thisisimportantwhenconsideringtheextension

toinsurersofregulatoryproposalsinitiallydesignedforbanks.

1.1. The nancial crisis: the different effects on banks and

insurers

Thestoryofthenancialcrisisisnowfamiliar,andadetailedtimelineofthecrisisisprovided

intheappendix.DecliningpropertyvaluesandclimbingdefaultratesintheU.S.ledtowrite

downsin mortgageassets. In 2007Countrywide,the largest subprimemortgageoriginatorin

theU.S.becameinsolventandBearStearnsbailedouttwoofitshedgefundsthathadinvested

heavilyinriskysecurities.InMarch2008,BearStearnswasrescuedfromfailurebyJPMorgan.

Exhibit 3: Chronology of the crisis market developments 2007-2009

800

1,000

Peak in equity

market prices

Br

Leh

(1

Bear Stearns

collapse

(March 2008)

bps)

800

0

200

400

600(October 2007)

CDSSpreads(

0

200

400

600

AllexceptS&P500

(indexed)

Jan-07 Jul-07 Jan-08

Source: Bloomberg, Datastream (US CDS spreads have been

US ins. sector CDS 5Y EU ins. sector CDS 5Y

eakdown of

man Brothers

5/09/2008)

AIG bailout

(16/09/2008)

Equity market

recovers

120

(March 2009)

S&

(in

0

20

40

60

80

P500

exed)

Jul-08 Jan-09 Jul-09 Jan-10

djusted to exclude AMBAC and MBIA)

S&P 500VIX US (USD ) 1M FWD 5Y swaption implied vol.

ByOctober2008AIG,FreddieMacandFannieMaehadbeenrescuedwithtaxpayersfunds

andLehmanBrothershadbeenallowedtofail.Uncertaintyaboutthesolvencyofmajorbanks

1. Setting the scene


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12


withexposuretotoxicassetscausedtheinterbankmarketstoseizeup.Tostaveoffeconomic

calamity, governments propped up the nancial sector with extended deposit guarantees and

massiveinfusionsofdebtandequitycapital.

Not all kinds of nancial rm were equally responsible for the crisis, nor equally

affected by it. Specically, the crisis had a less dramatic affect on insurers than on banks.The crisis hit insurers later, required far less additional capital and had less affect on new

businessvolumes.

Exhibit 4: U.S. nancial stress index 2007-2009

5

6

Values higher

than 2 indicate

March 17:

Collapse of

Bear StearnsOct

0

1

2

3

severe stressof equity

-2

-1

Jan-07 Jul-07 Jan-08

Source: Zurich Financial Services

The index is a weighted average of the following seven weeklycorporate bond in the investment grade sector, Equity volatility

, - ,

transformation (for example log-differenced) and is standardise

The weights of each series is determined by a principal compon

November 19:

Fear of huge credit

card debts

ober 8:

March 6:

Renewed concerns

about banks' health

September:

Collapse of

Lehman and AIG

arkets

Jul-08 Jan-09 Jul-09 Jan-10

ata series: Spread on corporate bond in the high yield sector, Spread oneasured by CBOE VIX, Equity index measured by S&P 500, LIBOR-T-Bill

. -

, in other words each series has mean zero and standard deviation one.

ent analysis. Finally, the compound series is standardised.

1.1.1. Insurers vs. banks: capital and capacity

Lossesintheinsuranceindustryhavebeenonlyasixthofthoseatbanks,andthenewcapital

raisedonlyaninth.AIGaloneaccountsfor58percentofnewcapitalintheinsurancesector

and36percentofthecreditlosses,whichwereincurrednotinthecourseofcharacteristic

insuranceactivitiesbutbyAIGsmassivecreditdefaultswap(CDS)exposures .ExcludingAIGfromthegures,bankshadtoraise20timesmorecapitalthaninsurers.

Thesecomparativelysmalllossesunderscorethattheinsuranceindustryhaslostlittlebusiness

capacity,asmeasuredbyshareholdersequity.Infact,mostinsurerswereinapositiontoabsorb

comparativelylargecreditlossesontheirbalancesheets,whereasmanybankshadtotakerecourse

topublicfunding.


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13

Exhibit 5: Re-capitalisation and credit losses

Total capital raised1

Cumulative from 2007 (USD BN)

Total capital raised

Cumulative from 2007, as % of 2006 Shareholders Equity

Credit losses

Cumulative from 2007, as % of 2006 Shareholders Equity

Credit losses

Cumulative from 2007 (USD BN)

0

500

1,000

1,500

2,000

Insurers Banks

X 6

USD 271 BN

USD 1,715 BN

0

300

600

900

1,200

1,500

Insurers Banks

Europe AIG Other American Asia ING

USD 170 BN

USD 1,468 BN

X 958%

16%0%

20%

40%

60%

Insurers Banks

X 3.5

68%

26%

0%

20%

40%

60%

Insurers Banks

X 2.6

Banks suffered larger losses and required more

capital on an absolute basis

Source: Bloomberg (as at 10 Feb 2010), Oliver Wyman analysis, Datastream

1. This is equity and preferred share capital raised, from states and through the capital markets. It does NOT include asset relief or lending

provided by states that did not require a capital consideration

as well as on a relative basis

1.1.2. Insurers vs. banks: stable volume and pricing

Intherunuptothecrisis,leverageincreasedmaterially.Asset-backedcommercialpaperin

issuancepeakedattheendof2007,fallingawayduring2008asappetitesfortheunderlying

securitiesdeclinedandBearStearnswasrescuedbyJPMorgan.Asthecrisisdeepened,interbanklendingdroppedbymorethanhalfintheU.S.andliquiditywasrapidlywithdrawnfromnancial

markets.

Exhibit 6: Rise and fall of wholesale funding and interbank lending

US Asset Backed Commercial Papers (ABCP) in issuance & US Interbank lending volumeIndexed at 100 in December 2005

0

20

40

60

80

100

120

140

160

180

200

Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09

Asset Backed Commercial Paper Interbank Lending

Source: US Federal Reserve, Oliver Wyman analysis, Federal Reserve Board

Q3 2008: +72% since Jan 06

Q2 07: Withdrawal of

ABCP liquidity

Fallen 62%, from

USD 1.3TN to 0.4TN

Q3 08: Collapse of

Lehman shuts

interbank market

Index31/12/2005=100

Setting the scene


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14


Duringthecrisis,centralbankspumpedliquidityintothebankingsectorinanattempttodrive

downinterestratesandencourageprivatesectorborrowing.However,therewasasignicant

increaseincomplaintsaboutcreditavailabilityandcreditcostbybusinessclientsandconsumers.

Exhibit 7: Borrowing rates during the crisis

5%

6%

EURIBOR and average interest rate on ne

December 2005-2009

1%

2%

3%

4%

InterestRates(%)

0%

Dec-

05

Mar-

06

Jun-

06

Sep-

06

Dec-

06

Mar-

07

Jun-

07

S

0

EURIBOR EU average interest on

Source: ECB, Oliver Wyman Analysis

loans

Q3 08: EURIBOR falls asBase Rate is slashed

p-

7

Dec-

07

Mar-

08

Jun-

08

Sep-

08

Dec-

08

Mar-

09

Jun-

09

Sep-

09

Dec-

09

new corporate loans Spread over EURIBOR

However,insurancepremiumshaveremainedrelativelystableduringthecrisis,reectingthe

industryssuperiorcapitalposition.Insurancemarketsremainedliquidandaclearingpricewas

alwaysavailable.

Exhibit 8: Insurance pricing during the crisis

Non-Life Insurance price changes i

year)

Casualty

Q1 & Q2 2007 Q1 &

France 10-20 1

Germany 10-20 1

UK 10-20 1

Italy 0

Spain 10-20 1

Property

Q1 & Q2 2007 Q1 &

France 10-20 1

Germany 10-20 1

UK 10-20

--

Spain 10-20 2

Motor

Q1 & Q2 2007 Q1 &

France 10-20

Germany 10-20

UK 10-20

Italy 0

Spain 10-20 2X% Decrease Flat

Source: Marsh EMEA Insurance Reports 2007,

n Europe (% from previous

Q2 2008 Q1 & Q2 2009

0-20 0

0-20 0-10

0-20 0-10

0-10 0

0-20 20-30

Q2 2008 Q1 & Q2 2009

0-20 0-10

0-20 0-10

0-10 0-10

- -- -

0-30 20-30

Q2 2008 Q1 & Q2 2009

0 0

0-10 0

0-10 0

0-10 0-10

0-30 0X% Increase

2008 and 2009


25/129

15

1.2. The effects of the crisis on the insurance industry

Althoughthecrisishasgenerallyhadfarlesseffectoninsurersthanbanks,someinsurersdid

runintoserioustrouble.Forexample,intheU.S.asofmid-2009onlythreeinsurancecompanies2

had taken TARP3 funds.At the time 592 bankshad accessed the programme. Ingeneral, the

severityof insurers lossesdependedon theirbusinessmodel. Specically,thoseinsurerswithlargebankingoperationsorotherexposuretocreditrisksufferedthegreatestlosses:morethan90

percentoftheStatesupporttotheentireinsuranceindustrywasgiventothosefewinsurerswith

signicantbankingactivities.4

Exhibit 9: Crisis impact by exposure to banking in operations

Type

Size and risk of banking operations within insurance companies triggered insurers performance

None/limited

banking activities

Insurance companies

with none or

limited banking-

type operations

Bank-insurance

conglomerates

Insurance

conglomerates with

significant banking

operations in multiple

countries

Wholesale banking

operations

Insurance companies

engaged in

highly risky

wholesale banking

activities using

non-insurance entities

Monoliners

Insurance

companies selling

only financial

guarantee insurance

highly leveraged

and concentrated on

US public and

structured finance

Some examples

of exposure to US

housing market

leading to

State intervention

No evidence tosuggest systemic risk

Problems in banking

operations easily

sufficient to

overwhelm total

conglomerate

Insurance balancesheet ring-fenced

Severe problems

in wholesale

credit operations

unconnected

to insurance

balance sheet

Systemic threat

Severe losses led to

questioning of

business model

in general

(AMBAC, MBIA)

Systemic threat

Charac-

teristics

USD 8 BN USD 40 BN USD 180 BN Questioning of

business model

Perfor-

mance

State

support1

1. State support reflects capital injections and asset support provided by states. Exchange rates as of 31.12.2008

Source: Bloomberg, Company Reports, Oliver Wyman press search, Oliver Wyman analysis,

1.2.1. Insurers with limited banking activities

Insurerswithlimitedbankingoperationsincurredlimitedlosses.Despitetheturmoilinthe

interbanklendingmarkets,theinsurancemarketsremainedopenandinsurersoperatedasnormal.

Insurerswerecontaminatedbythebankingsectorinseveralways:

mark-to-marketdecreasesinvaluationof(subprime)mortgage-backedsecurities,corporatebondsandequitiesheldbyinsurers;

reducedliquidityofcertainassets;

increasedvolatilityofnancialmarkets(e.g.forvariableannuities);

exposurestodefaultedbanks(e.g.Lehman);

liquiditycrunchinthebankingoperationsofinsurers;

generaleconomicslowdown.

Lifeinsurerssufferedgreaterlossesthannon-lifeandcompositeinsurersbecausetheyhad

relativelygreaterexposurestonancialinstruments,throughembeddedderivativesinliabilities

2. U.S. Department of Treasury Ofce of Financial Stability Transactions Report (for the period ending July 16th 2009).

3. Troubled Asset Relief Program.

4. State support reects capital injections and asset support provided by States.

Setting the scene


26/129

16


andlargerinvestmentportfolios.TheU.S.lifeinsurersTheHartfordandLincolnreceivedState

aid to bolster their capital, having suffered losses from their exposure to devalued nancial

instruments.InJapan,YamatoLifeledfor bankruptcy.U.S. creditmarketexposureandhigh

levelsof anxiety onDutchnancialmarkets, contributing to widespread fears that any large

Dutchprovidercouldbeatrisk,ledAEGONtoaccepttemporaryStateaid.

Nevertheless,lifeinsurersexposuretoCDSandotherstructuredproductswassmallcompared

withbanks.Thisisaresultoftheirstrictunderwritingpoliciesandmodestlevelsofactivities

undertakenoffbalancesheetorthroughsubsidiaries.

Exhibit 10: Insurance companies affected during the crisis

Lincoln received USD 950 MM of funding through the US

Troubled Asset Relief Programme

Having suffered 5 consecutive loss making quarters, their

capital position had been eroded Losses were chiefly generated through their exposure

to the US housing market, through securitizations and

direct lending

Market commentators did not consider Lincoln to be in

immediate solvency danger, and that the recourse to TARP

funds may have been opportunistic

The funds have yet to be repaid

Lincoln National Corporation

US Life Insurer

33rd largest Japanese life insurer

Filed for bankruptcy on 10 October 2008, nearly a month

after the rescue of AIG

Debts exceeded assets by 11.8 BN (USD 117 MM) Operational inefficiency resulted in a high cost base

In an attempt to cover these costs, Yamato chased higher

yields, investing in the US housing markets

Bankruptcy was a result of poor investment and operational

management, rather than liquidity or exposure to other

financial institutions

Yamato Life

Japanese Life Insurer

USD 1.7 BN realized investment losses in 2008

(40% on CMBS portfolio)

Losses on assets trigger USD 1.0 BN of charges forguarantees in VA business from Q3 2008 to Q3 2009

VAs accounted for over 20% of The Hartfords USD 3

BN profit in 2007

VA guarantees include annual withdrawals of up to 7%

USD 5.9 BN raised capital

USD 3.4 BN capital injection by TARP

USD 2.5 BN invested by Allianz

The Hartford

US Composite InsurerAEGON

International Life Insurer(HQ in Netherlands)

Historic exposure to US credit markets from large US

operations (~ 2/3 of its business)

Total gross credit exposure of 390 MM to Lehman and

Washington Mutual

2.5 BN unrealised losses on credit portfolio

2008 strategy shift - already re-balancing

geographic profile

Dutch financial sector events created contagion fears

3 BN injection from Dutch government to bolster capital

and allow AEGON to retain AA rating

33% repaid in December 2009

Source: Oliver Wyman analysis, annual reports, press research

1.2.2. Bank-insurance conglomerates

Unsurprisingly,bank-insuranceconglomerateswerehitharderbythecrisisthanpureinsurers.

Thereislittledifferencebetweentheimpactofthecrisisonabank-insuranceconglomerate(e.g.

Fortis)andonaninsurance-bankconglomeratewithasimilarbankoperation(e.g.ING).5

ING is the largest insurance/bank conglomerate. Including asset relief ING received

more than USD 40 billion in State support. Its difculties stemmed from its banking

operations and especially its acquisition of a U.S. thrift when expanding its online savings

division.ThisacquisitionmadeINGsubjecttoregulationbytheOfceofThriftSupervision

(OTS). To comply with local thrift regulation, which requires more than 55 per cent of

assets to be allocated to mortgages, ING acquired a large portfolio of MBS, backed by

Alt-Amortgages.

When default rates on Alt-A mortgages began to climb, the market value of the

MBS portfolio plummeted, requiring ING to increase the quantity of capital it held

against them. In 2008, ING reported fair value losses of 2.6 billion on credit assets and5. By bank-insurance conglomerate we mean a combined bank/insurance group listed as a bank; by insurance/bank

conglomerate we mean a combined bank/insurance group l isted as an insurer.


27/129

17

1.7 billion on equity securities. In October 2008 the Dutch government invested

10billioncapitalinINGandinFebruary2009ittookover80percentofINGsAlt-Aportfolio

at90percentofitsfacevaluefor20billion.6

Thebankinsurancemodelhashowevernotbeeninvalidatedasaresultofthecrisissincenot

allbank-insuranceconglomerateswerehoweverhitbythecrisis.Conglomerateswithbanksthathadstrongliquiditypositionsandlowinvolvementinstructuredproductscameoutofthecrisis

relativelyunharmed(BNPParibas,HSBC,CrditAgricole).

1.2.3. Insurers with wholesale banking operations: AIG

AIGwastheheadlinenear-failureinthe insuranceindustry.However,thesourceoftrouble

wasnotitsinsuranceactivitiesbutitsFinancialProductsdivision(AIGFP).AIGFPwasfounded

in1987asAIGscapitalmarketsdivision,domiciledinLondon.SincetheAIGholdingcompany

wasregisteredwithanequivalentregulator,theUSOfceofThriftSupervision(OTS),AIGFP

wasabletoevaderegulationbytheU.K.FinancialServicesAuthority(FSA).

AlthoughAIGFPhadalwayscontributedonlyasmallportionofAIGsrevenues,itmadehighlyleveragedtransactions.AsofSeptember2008,thenotionalvalueofAIGFPsderivatives

portfolio,concentrated in U.S. housing market and corporate CDOs and CLOs, was USD 2.7

trillion,ofwhichUSD440billioninwrittenCDSwasguaranteedbyAIGHolding.

Exhibit 11: AIG revenues by division

Asset Mgmt.

Foreign Life &

Retirement

28% US non-life Ins.32%

AIG 2005 revenues by business lines

5%

AIG FP

3%

US Life &

Retirement

15%

Foreign

General Ins.

11%

Financial Services

w /o AIGFP

6%

Sources: AIG Annual Reports

1. 2005 revenues shown as they represent the peak of

AIG FP vs. AIG revenues 2003-2008

80

120

160

inUSDB

N)

-80

-40

0

2003 2004 2005 2006 2007 2008

Revenues(

AIG FP Other AIG entities

IG FPs contribution to AIG revenues

AIGsproblemsbeganin2007.FollowingdowngradesofU.S.subprimesecurities,AIGsCDS

counterpartiesdemandedcashcollateral.InSeptember2008,AIGscreditratingwasdowngraded

from AA- to A-, triggering further cash collateral calls on its CDS contracts and securities

lendingprogramme.Unabletomeetthesecalls,AIGwasbailedoutbytheU.S.Treasuryon18th

September.Bytheendof2009,AIGhadreceivedatotalofUSD182billionoftaxpayersfunds. 7

TherearethreeimportantfeaturesofAIGFPsbusinessthatshouldbenoted.First,itwas

highlyleveraged:thetotalexposureofAIGFPwasmassivelygreaterthanitsassetbase.Such

leverageisnotpossibleinaregulatedinsurancebusiness.Second,thecollapsewastriggered

bya collateralcall, notan actualcredit event.Again,this isgenerally notpossible ininsurance

6. ING annual reports.

7. USD 70 billion government investment, USD 60 billion credit line and USD 52.5 billion to buy mortgage-linked assets

owned or backed by AIG (Bloomberg).

Setting the scene


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18


contracts,whichpayoutonlywhenaninsuredevent(are,theft,lossoflife,etc.)hashappened.

Third,usingregulatoryarbitrage,AIGFPoperatedeffectivelyunregulated.Responsibilityfor

supervisionhasbeenacknowledgedbytheOTS.EventhoughtheOTSwasawareofAIGFPs

CDSexposureandtheguaranteesissuesbyAIG,theOTSdidnotattributeanyliquidityriskto

thissituation.Haditdoneso,theOTSwouldhavehadthepowertorequestreductionofCDS

exposure.

ThatAIGwasengagedintheseactivitiesatthisscalewasclearlyafactorwhichworsenedthe

globalcrisissignicantly.Interestingly,however,itcausedlimiteddamagetothecoreinsurance

businessesofAIG.

1.2.4. Monoliners

The group of nancial guarantors known as the monoliners (FSA, AMBAC, MBIA

etal.)wereamongthecasualtiesandarguablyamongthecausesofthecrisis.However,they

haveaverydifferentbusinessmodelfromtraditionalinsurers,withtheirexclusiveconcentration

onnancialguarantees.Ithasbeenarguedthatthe monolinersplayeda roleingeneratingandamplifyingthecrisis,andquestionshavebeenraisedabouttheirbusinessmodel.

Monolinershavehistoricallyprovidednancialguaranteestoreducetheborrowingcostof

U.S.municipalities(creditenhancement).Theirsolebusinesswastotakecreditrisk.Thecredit

riskhistoricallytakenwasdiversiedmunicipalriskofhighquality.Municipalshadverylow

losseshistorically.Asaresult,monolinershadacapitalpositionbasedonthatlowriskcredit

prole.Theybranchedout intostructured nancein the1990s rstinsuringtimely paymentof

interestandprincipaloffundedcashbonds;theylatermovedintonancialguaranteeassociated

withCDSofinvestmentgradecorporatecredit.Lastlytheytookonnancialguaranteesassociated

withCDSofCDOandMBSthatweresuperAAArated.

Theseactivitieshavethepotentialtotransmitlosseswhenthecreditratingoftheproviderof

thenancialguaranteeisdowngraded.Thisleadstoadevaluationofthewrappedsecuritiesand

mark-to-marketlossesforwhoeverholdsthem.

Themonolinersbuiltupundiversied,highlyleveragedportfolios,takingadvantageofthe

fact that a CDS backed by MBS requires less capital coverage than a municipal bond.This

businessmodelreliedheavilyonstrongcreditratings(asdidAIGFP)and,atthesametime,was

vulnerabletoerrorsofriskestimation.

Monolinersgenerallydidnotagreetopostcollateralundertheircollateralservicingagreements

because they lacked sufcient liquidity to support collateral calls. This heightened anxiety at

theircounterparties,whobecameconcernedthattheseinstitutionswouldcollapseleavingthe

counterpartiesunprotected.Thissituationeffectivelycreatedacondencecrisisinthemonoliners

evenathighratings.

Monolinersbusinessisdifferenttotraditionalinsurance,andwewouldsuggestthatregulators

considerthesystemicriskfromsuchinstitutionsexactlyastheywouldforanyhighly-concentrated

creditinstitutioninthebankingsectororelsewhere.


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19

Exhibit 12: Monoliners exposures during the crisis

MBIA

Net par amount written by bond type

0%

25%

50%

75%

100%

2006 2007 2008

US Public f inance US Structured f inance

Non-US Publ ic f inance Non-US Structured f inance

1.1% 1.1% 1.2%

0.4%

-0.9%

-2.0%

-1.0%

0.0%

1.0%

2.0%

2004 2005 2006 2007 2008

Source: MBIA and AMBAC annual reports

Monoliners leverage Monoliners exposures

1.1% 1.1% 1.2%

0.5%

0.1%

0.0%

0.5%

1.0%

1.5%

2.0%

2004 2005 2006 2007 2008

MBIA

Equity/net par amount outstanding

AMBAC

Equity/net par amount outstanding

AMBAC

Gross par amount written by bond type

0%

25%

50%

75%

100%

2006 2007 2008

Public finance Structured finance

International finance

Exhibit 13: Monoliners correlation to the housing markets

Indexed US Mortgage Default Rates and C

160

180

200

defaultrates

xed)

80

100

120

Dec-05 Jun-06 Dec-06 Jun-07

USMortgag

e

(Ind

US housing default rates

Source: Datastream, Oliver Wyman Analysis

AA

AAAMBAC

MBIA

Evolution of S&P ratings

DS spread time series

6,000

8,000

10,000

CDSspr

Dec-07 Jun-08 Dec-08 Jun-09 Dec-09

0

2,000

4,000

e

ad(bps)

MBAC CDS spread MBIA CDS spread

BB-BBBB+A-AA-

BBBBBA CC

Setting the scene


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20


1.2.5. Conclusion

The insurance sector as a whole did not suffer the severe and widespread losses that the

bankingsector did.Where insurersencountereddifcultiesitwas predominantlythrough their

non-insuranceactivities.

1.3. Why did insurers fare better?

Insurersdonotrelyonwholesalemarketfundingforliquidity.Theyfundthemselvesthrough

premiums,withlong-termcapital tosupportrisk-taking positions.Their assetbases,whichare

substantialcomparedtotheircash-ows,mostlycomprisehighlymarketablesecurities.Whilst

insurersdoinvestinsomeilliquidorhigher-risksecurities,theirstrongtraditionofenterprise

risk management(which strengthened after the previous 2001-2003 equity crisis) and highly

regulatedbalancesheetsbothservetolimittheproportionofassetsatrisk.

Thus, during the crisis this natural long-liquidity position allowed insurers to be largely

unaffectedbytheliquiditycrunch,andinsurersinvestmentactivities,whichareguidedbytheneedtomatchliabilities,wouldhaveenabledthemtosurviveevenaprolongedandturbulent

marketdownturn.

Exhibit 14: Insurers cash-ows by source

5.1%

(3.7%)8.7%

12.0%

16.0%

hflo

w

Composition of Free Cash Flow yield for

generated by the life Value of In Force (VI

5.7%

0.7%

0.0%

4.0%

.

Freeca

nsurance

TotalLife

entreturn

essstrain

eneration

Generali

Investm

New

busin

Cashg

Source: Fat Tail Friday, Morgan Stanley Research esti

(5.7%)

(2.6%)(0.9%)2.3%

0.8%

uropean insurers the majority of cash is

) business unwind, FY09E

4.7%

10.4%13%

plusafter

dividends

ividends

low

Yield

inCapital

irements

Earnings

Other

Banking

agement

E

stimatedSur

FreeCash

Growth

req

TotalCash

Fundma

ates July 18 2008

Thedependabilityofinsurerscash-owsfromlargebackbooksofreliableinstitutionaland

retailcustomersallowedthemtocontinuetomakenetinvestmentsinsecuritiesatatimewhen

bankswereforcedtosellsecurities.


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21

Exhibit 15: Operating net cash-ows and investments by major European insurers

Net cash flows from operating activities

Top 5 European insurers

-50

0

50

100

150

2005 2006 2007 2008 H1 2009Cashflowfromoperations

(USDBN)

Allianz Aviva AXA ING Generali

Net investmentsTop 5 Insurers

-50

0

50

100

150

200

2005 2006 2007 2008 H1 2009Netinvestments(USDBN)

Source: Annual Reports, Oliver Wyman Analysis

1. Top 5 insurers by assets at 31.12.2006 in USD terms

Thestrengthofinsurerscash-ows,andtherelativestabilityoftheirbalancesheets,meant

thatinsurerswereabletomeettheirobligationsand,wherenecessary,toraisenewdebtcapital.

Exhibit 16: Estimated cash coverage of insurance companies

Source: Company data. European Life Goldman Sachs 2009

1: Normalised cash flow, pre-interest and tax, (excluding impairments) cover of interest expense

Estimated cash interest coverage of European life insurers1

0

1

2

3

4

5

6

7

L&G ING Prudential Generali Aegon AXA Std Life

Minimum to

meet obligations

Surplus

Setting the scene


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22


Exhibit 17: Insurance debt issuance during the crisis

Source: Company data. European Life Goldman Sachs 2009

Debt issuance by European Life Insurers

2007-2009 (BN)

0

2

4

6

8

10

Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09

1.4. Conclusion

With a few notable exceptions, the insurance industry passed through the crisisrelatively

unscathed.Thoseinsurersthatencounteredthemostsignicantdifcultiessufferedthroughover-

exposuretonon-coreactivities.AIGisaclearexampleofthis.Itwasbroughtdownnotbyits

insurancebusinessesbutbyitscapitalmarketssubsidiary,AIGFP.Consequently,anyadditional

regulationforsystemicriskneedstotakeintoaccounttheactualactivitiesbywhichaninsurer

mightposesystemicrisk:thisisthefocusofourworkinthisreport.


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23

TheFSBandtheIMFrecentlydenedwhatsystemicriskmeanstothem.

G20nanceministersandcentralbankgovernorsendorsedthisdenition.

Exhibit 18: Denitions of systemic risk and systemic relevance

The risk of disruption to the flow of financial

services that is (i) caused by an impairment of

all or parts of the financial system; and (ii) has

the potential to have serious negative

consequences for the real economy

Fundamental to this definition is the notion that

systemic risk is associated with negative

externalities and/or market failure and that a

financial institutions failure or malfunction mayimpair the operation of the financial system

and/or the real economy

Source: FSB, IAIS

relevant institutions

Size: The volume of the volume of financial

services provided by the individual component

of the financial system

Interconnectedness: Linkages with other

components of the system

Substitutability: The extent to which other

componen s o e sys em can prov e e

same services in the event of a failure

Timing:Allow for the fact that systemic

insurance risk does not typically generate

immediate shock effects, but plays out over a

longer time horizon

The FSB denition is the most commonly referenced when systemic risk is discussed in

supervisoryandregulatoryforums.Wewillusethisdenitionasastartingpointforthediscussions

inthisdocumentalthoughthereisanactiveandongoingdebateaboutthedenitionofsystemic

risk.8

TheFSBhassetoutsomecriteriasize,interconnectednessandsubstitutabilitybywhichtherelevanceofparticularinstitutionstosystemicriskmaybeassessed.TheFSBhasalsospecied

secondarycriteria,qualiedascontributingfactors,thatpotentiallyincreasethevulnerabilityof

someinstitutions:namelycomplexity,9leverageandliquidityriskandlargemismatches.

8. Note: One company represented by The Geneva Association in this report disagrees with the FSB denition.

9. An institution can be qualied as complex if it

(a) operates diverse types of activities through numerous legal entities (e.g., simultaneously operating banking,

insurance and securities subsidiaries)

(b) operates across borders with centrally managed capital and liquidity (as opposed to simpler networks of national

subsidiaries)

(c) has exposures to new and complex products and markets that have not been sufciently tested.

Complexity per se would not be enough to guarantee a large systemic impact. However, countries may see complexity

as a source of vulnerabilityin particular if complexity is also associated with lack of transparency, difculties inunderstanding the exposures taken by the institution, and the potential magnication of information asymmetries in

the case of a systemic event (Source: FSB Guidance to Assess the Systemic Importance of Financial Institutions,

Markets and Instruments: Initial Considerations).

2. FSB and IAIS denition

of systemic risk


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24


The IAIS have proposed adding time to these criteria, reecting the critical role that

timing (speed) plays in whether an event transmitted into the nancial system can be

absorbed by the system. We agree with this addition, and note its particular importance

toinsurance.

However,evenwhilstacceptingthebasiccriteriathattheFSBhasputforward,itisimportanttonotethattheimpactofthesecriteriaonnancialsystemriskcanbeverydifferentfordifferent

activities.Inthischapterweillustratethispointwithreferencetodifferentactivitiesthatnancial

institutions,betheybanksorinsurersmightcarryout.Ouraimisnottoarguethatthecriteria

arewrong,orthattheydonotapplytoinsurers,onlythattheyneedtobeappliedtoactivitiesand

nottoinstitutions.Applyingthecriteriablindlytowholeinstitutionsrisksaddinganadditional

regulatoryburdenonsystem-stabilisinginstitutionswhilstpotentiallymissingsomeinstitutions

carryingoutactivitieswhichdoposeasystemicrisk.Focusingonalistofinstitutionsisunlikelyto

detectormanagesystemicrisksmoreeffectively;instead,itislikelytoencourageriskmigration,

leadtounderestimationofsystemicriskandcreatedistortingmoralhazard.

2.1. SizeSizeisacrudemeasureofrisk.IfnoaccountistakenofEconomicCapital,thenassetsand

marketcapitalisationdonotmeasurerisk.Forexample,largeinsurersaretypicallywelldiversied

bothgeographicallyandacrosslinesofbusiness.Thisreectstheirbusinessmodel,whichcauses

themtobeexposedtoawiderangeofinsurance,market,businessandotherrisks.Becausethese

Exhibit 19: Economic capital by risk source

79%72%

40%

10%

23%

7%13%

4%

8%

36%

30%

41%

43%25%

17%

19%

45%

37%

7%9%

6%

28%

5%

1%

10% 11%

18%

32%

11%

8%7%

3% 2%

0%

20%

40%

60%

80%

100%

Commercial

Banking

Retail

Banking

Sales &

Trading

Asset

Management

Life

Insurance

P&C

Insurance

Reinsurance

Credit Market

Life Insurance P&C Insurance

Business Operational

Other

Source: 2006 ECAP Survey, IFRI CRO Summary, prepared by Oliver Wyman Companies Annual Reports

Breakdown of Economic Capital for European banks and insurers

Financial risks

Non-financial

risks


35/129

25

risksareforthemostpartidiosyncraticandlargelyuncorrelated,thetotalrisktotheinstitutionis

lessthanthesumoftheindividualrisks.Thisdiversicationhelpsexplaintheresilienceofmost

largeinsurersduringthecrisis,anditisnotablethatatypicallargeinsurerismorediversied

thanatypicallargebank.Thussizeneedstodistinguishbetweenconcentrationofexposuresand

dilutionofriskthroughdiversication.

Size is of courseimportant, and it need not alwaysbe the case that a large bank is less

diversiedthanalargeinsurer.Buttherefore,thesignicanceofsizeforsystemicriskdepends

onthecompositionofaninstitutionsactivities,itsrespectivesizeanditsinterplaywithother

systemicriskfactors,suchasinterconnectedness.Itisnotsizeas suchthatpresentsdangerbut

undiversiedsize.Thisisthelessonofthemonoliners.Takingsizeasaninstitutionalvariable

ignoresthisproblem,andrisksthewrongjudgementsbeingmadeaboutsystemicrelevance.

2.2 Interconnectedness

Interconnectedness is a necessary condition for systemic relevance. Only if risk can be

transmittedcananinstitutionoritsactivitiespresentariskforthesystem.

Interactionsbetweeninstitutionswithinthenancialsectorareofdifferentkinds,including,

forexample,cross-ownerships,paymentsystemsinteractionsandexplicitrisktransferoperations

(reinsurance,derivatives).

But apparently similar types of interconnectednesscan have quite different effects onthe

nancialsystem.Bywayofexample,weconsidertwotypesofrisktransferactivity:reinsurance

transactionsbetweeninsurersandreinsurers,andCDStransactionsbetweenbanks.Bothinvolve

severalparties.However,whereasreinsurancetransactionsmitigatesystemicrisk(bysharingthe

existingrisksamongmanyplayersandallowingdiversicationofexposures),CDStransactions

canexacerbateit.And,whereasreinsurancetransactionsareasmallproportionoftheaggregate

insurancebalancesheet,pre-crisisCDStradingwassignicantinrelationtothetotalbanking

balancesheet.

Exhibit 20: Interconnectedness: insurance vs. banking

Comparison of inter-connectedness betw

Insurance

Low level of premiums ceded by insurers

USD BN

4,218

1,782

2,436

2.4% 5.6%

55% 28%

Ins uranc e Reins uranc e R et ro ces sio ns

15960

Life insurance Non-life insurance

Source: Swiss Re sigma, IAIS Global Reinsurance Market RepoNote: It should be noted that the insurance values are a flow wh

.

en insurance and banking operations

Banking

CDS notional exposures represent ~41 % of

worldwide banking assets, USD BN

95% of single name CDS

outstandings transacted

between banks

19,184

15,347

36,046

88,400

515

rt 2009, BIS, Oliver Wyman analysesreas the CDS is a stock Figure. However, the comparison of the

1,000

largest

banks

assets

TotalCDS

outstandings

Reporting

dealers

Banks

and

securities

firm

s

Others

1,000largest

banksassets

TotalCDS

outstandings

Reporting

dealers

Banksand

securitiesfirms

Others

FSB and IAIS denition of systemic risk


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26


Reinsuranceeffectivelysharesariskwhosesizeislimitedtotheunderlyinginsurableinterest,

betweenseveralparties,andallowsdiversicationofexposures.Moralhazardismitigatedbecause

theprimaryinsurerremainsexposedtoaportionofanylossesinareinsurancetransaction.This

linksthedestinyofthecedinginsurerandthereinsurerinanytransaction.

Inthecontextofnaturalcatastrophesthestructureoftheinsuranceindustrygivesittwolinesofdefence.Reinsurerstakeonpeakrisksandactasarstlineofdefenceforextremeevents

(e.g.catastrophes),providinga rewallthat protectsprimaryinsurersfrommassivelossesand

potentialfailure.Intheeventofpeaklossescausingthefailureofreinsurers,thecapitalofprimary

insurersprovidesasecondlineofdefence.Itisintheorypossibleforaneventtobesohugethatit

overwhelmstheentireinsuranceindustry,butthiswouldthenbeanationalorglobalcatastrophe

ofunimaginablescale(forexample,HurricaneKatrinawaswellwithintheindustryscapacity).In

thiscircumstancetheeventwouldhavecausedtheloss,nottheactivitiesofinsurancecompanies.

InterbankCDStransactions,bycontrast,candisconnecttheriskfromholdingtheunderlying

exposure. When Lehman Brothers defaulted in September 2008, it had USD 155 billion in

outstandingdebt,yetUSD400billionofCDSreferencingthisdebthadbeensold.Itistherefore

possiblefortheCDSlossesarisingfromaneventtoimpactmanymoremarketparticipantsinasubstantialwaythantheeventitself;themarketinterconnectednesscanleadtoacontagionofthe

wholesystem.

Thiscontagionisaggravatedbytheproblemofopacity.Thecomplexityofmanyderivatives

andthefactthatmanyaretradedover-the-counterratherthanthroughexchangesmakeitdifcult

toassesstheriskpositionofinterbankcounterparties.Thisopacitywasanimportantfactorforthe

lossofcondenceatthepeakofthecrisisinlate2008.Inter-insurancermtransactionsenjoya

muchhigherdegreeoftransparency,beingdominatedbyasmallnumberofstandardmechanisms

thatarewellunderstoodbytheplayersinvolvedandthewidermarket.

Again,wedonotarguethatinterconnectednessisnotarelevantcriterionforassessingthe

systemic risk ofan insurer. Rather, we pointout that the interconnectednesscan bea highlysignicantfactorforsomeactivities,whereasforothersinterconnectednessisoflittlerelevance.

2.3. Substitutability

Thesubstitutabilityofan institutionforanancialservicemustbeassessedbyconsidering

twoquestions:

Doestheinstitutionhaveanytechnicalspecicitiesorplaysuchauniqueroleinamarket

thatitwouldbedifculttosubstituteanequivalentactorintheshort-termiftheinstitution

weretodisappear?

Isthecapacitythattheinstitutiondeploystoitsmarketsolargeoruniquethatotherscould

notstepinwithcapacitysufcienttoenablethemarkettoclear?

By these tests, insurance activity is substitutable, and therefore not systemically relevant

by this criterion. Firstly, no insurer has a monopoly in any material line of insurance,

nor does one institution play a central market role such as clearing or acting as a

securitiesexchange.

Secondly,insurancecapacityissubstitutable.Insurersderivetheircapacitytowritebusiness

fromanumberofsources,includingexternalcapital.However,wecanseereinsurersastheultimate

providersofcapacityinthesystem:solongasreinsurersareofferingcapacity,insurerswillwrite

business.Butcapacityinthereinsurancemarketiseasilysubstituted.Afteranaturalcatastrophe,

reinsurancecapacitydeclinesandreinsurance prices typicallyincreaseforseveral years. This

cycleattractsnewcapitalowingtobothexistingreinsurersandnewentrants(includingcapitalmarketsthroughside-carsandcatbondsecuritisations)while(expected)higherprotstopup


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27

capital reserves. Because these prots are not risk-free there is noarbitrage opportunity, and

thereforethecycleislong-lastingenoughtorestoresufcientcapacitytothesystem.

Exhibit 21: Worldwide reinsurance capital inows 1990-2008

0

2

4

6

8

10

12

14

16

18

20

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Y ear

0

50

100

150

200

250

300

350

400

450

Non-Bermuda (Equity+IPO) Bermuda (Equity+IPO) Cat Bonds Side cars Guy Carpenter RoL Index (RHS)

Source: Thomson, Guy Carpenter, AON Benfield, Dealogic, Oliver Wyman analysis

No data on inflows1990-1993

Hurricane Andrew 9/11 Hurricane KatrinaNew capital flows into nat cat reinsurance industry and nat cat reinsurance rates

USD

BN

RateonLineIndex(1990=100)

Of course, the recapitalisation of the industry after a major catastrophe does not happen

overnight.Howeverthereisalsonoovernightsubstitutabilityproblem.First,thetimingcriterion

raisedbytheIAISisrelevanthere.Whileanimmediatesubstitutewouldberequiredforseveral

bankingactivities,thisisnotthecaseforallinsuranceservices(andaswenoteinsection2.6,the

processforwinding-upaninsureralsomeansthatthislossofcoveragewouldnotbeimmediate).Second,theinsuranceandreinsurancemarketsarehighlydiversiedbytheusualmeasures

withineachcountryandworldwideforreinsurance,soonlyaneventwhichdestroyedtheentire

industrycouldmakeitimpossibletopurchasenecessaryinsurancecover.

Exhibit 22: Concentration of European primary insurance markets

Herfindahl-Index of primary insurance (lif

insurance markets1, 2007 (2008 for Spain,

0.10

0.12

0.14

0.16

0.18

hl-Index

0.00

0.02

0.04

0.06

0.08

Sp ai n UK Ger many Net her la

Herfind

Source: Oliver Wyman European Insurance Database 2008

1 Index based on gross premiums written by European insurers0.1Index


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28


Exhibit 23: Concentration of the global and U.S. reinsurance markets

0%

20%

40%

60%

80%

100%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Number of considered reinsurers

Global US

Cumulative premiums by the largest reinsurers

Ranked in descending order by gross written premium, 2008

Source: AM Best, IAIS Global Reinsurance Market Report 2009, OW Press Research

1. Based on the Top 35 global reinsurers (gross written premium 2008: USD 156 BN) and the total gross written reinsurance premium according to the IAIS Global

Reinsurance

Market Report 2009 (2008: USD 159 BN) which is only considering reinsurers writing reinsurance in excess of USD 800 MM

2. Based on the Top 25 U.S. reinsurers (gross written premium 2008: USD 37.2 BN of total U.S. gross written premium of USD 37.7 BN)

Note: The Herfindahl index is a measure of the size of firms in relation to the industry and an indicator of the amount of competition among them; defined as the

sum of the squares of the market shares of the 50 largest firms

Cumulativegrosswritten

reinsurancepremiums

Duetotheorganisationandstructureoftheinsuranceandreinsurancemarkets,substitutability

is therefore not as relevant for insurance companies as it is for banks where exchanges and

paymentsystemsarecritical.

2.4. Timing

Insuranceclaims operate muchmoreslowly thanthe margin call,collateraland depositor

claimsonbanks.Forexample,lessthanhalfoftheclaimsontheWorldTradeCentreweresettled

twoyearsaftertheevent.Thisisadirectconsequenceofthenatureoflargeinsuranceclaims:they

relyinmanycasesonmultiplepolicies,courtjudgements,andindividualclaimants.

Exhibit 24: Timing of World Trade Centre claims payments

0%

20%

40%

60%

80%

100%

Q4 2001 Q4 2002 Q4 2003 Q4 2004 Q4 2005 Q4 2006 Q4 2007

Quarters after 11 September 2001

%o

ftotalnetclaimpaid

Cumulative proportion of claims made over time

Timing of World Trade Centre Insurance Claims

Source: Reinsurance Association of America, Catastrophe Loss Development Study


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29

The failure ofa bank and the consequent closure ofthe wholesale funding markets could

triggerthecollapseofthebankingsystemveryquickly.Bycontrast,thewind-upofaninsureris

likelytobeamoreorderlyprocess,asdiscussedinChapter2.6.Theslowpaceoffailureincreases

substitutabilitybyprovidingthetimerequiredtorebuildindustrycapitalandcapacity.Wecan

thusarguethatinsurancermfailurespresentlesssystemicriskthanbankfailures.Howeverin

doingso,wenotethatthedifcultiescausedbyAIGsFinancialProductsdivisionpresenteda

hugeandimmediatesystemicthreatinthejudgementofU.S.policy-makers:thisagainpointsto

theneedtoconsideractivities,ratherthaninstitutions,inconsideringsystemicrelevance.

2.5. Contributing factors to the assessment

of systemic importance

Each of the three further contributing factors (leverage, liquidity/mismatches and

complexity),independently,wouldnotcreatesystemicrisk,butshouldbeconsideredalongside

themaincriteria.

Wecantakeleverageandliquiditytogether,asinbankingactivitiesleverage(forexampletheuseofwholesalefundingtoincreasetheinstitutionslendingcapacityrelativetoitsdepositbase)

andliquiditymismatchesbothservetoexposetheinstitutiontotheriskofthewholesalemarket

drying-upforaperiodoftime.

But for typical insurancebusiness, the concept ofleverage is different from banking,and

therefore the nature of liquidity risk is different. Insurance activity is self-funding through

premiuminow,with long-termsourcesofcapitalusedtosupporttherisks accepted.Inother

words,leverageisnotpartofthebusinessmodelofinsuranceandinsurancecompaniesdonot

requireleveragetofunction.

Insurers do have to maintain appropriate liquidity, as they do have payments to make to

policy-holders.Many ofthese paymentsare plannedclaims andbenet payments,but insomeinstancespolicy-holdershavetheabilitytoacceleratepayments,throughpolicysurrenders.These

paymentsare funded,rst, throughpremiuminows,andnext throughsales ofsecuritiesheld.

Insurersarenotreliantonwholesalefundingtomeetpolicy-holderredemptionsorforanyother

coreinsuranceactivity.

Consequentlywhilstliquidityisarelevantissueforallnancialinstitutions,thenatureofthe

riskisverydifferentfordifferentactivities,asarethemetricsneededtomeasurethisriskandthe

actionsrequiredtomitigateit.

Finally,theFSBraisescomplexityasacontributingfactor.Complexitybyitselfisnotarelevant

issue,exceptinsofarasintra-grouptransactions,bypreventinganorderlywind-up,exacerbate

thesystemicriskfromthegroupsactivities.Forbanks,thisisparticularlythecasewherethe

intra-grouptransactionsarealsointer-country.Butforaninsurancegroupnotcarryingoutbankingactivities,intra-grouptransactionsareusedforcapitalmanagementefciency,shouldnotinterfere

withorderlywind-up(thisisdiscussedinmoredetailbelow),andshouldnotmaketheregulationof

theoverallentitymorecomplexaseachinsurancebalancesheetisaregulatedentity.Consequently,

forcertainactivities,complexityisasignicantcontributingfactor;forotheractivitiesitisof

norelevance.

2.6. Wind-up and run-off: insurance industry experience

Whileregulationattemptstolimitthepossibilityofinsolvencies,andinparticularinsolvencies

causedbyimprudentmanagementdecisions,companyfailuresassuchshouldnotbeconsidered

assomethingtobepreventedatanycost.Thedisappearanceofoldandappearanceofnewmarketparticipantsisanessentialelementofmarketeconomies.

FSB and IAIS denition of systemic risk

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geneva association systemic risk in insurance report march2010

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