Macro Prudential Policy and Financial Stability in the Caribbean: Insurance Industry Perspective

Ravi Rambarran

CEO Sagicor International

GARP Caribbean

Global Association of Risk Professionals

May 2015

2

The views expressed in the following material are the

author’s and do not necessarily represent the views of

the Global Association of Risk Professionals (GARP),

its Membership or its Management.

Macro Prudential Policy

• What is it for?

• Why is it needed?

• How should it be done?

• Who should be in charge?

• Will it work?

What is it for?• Objectives

– Limit financial instability

– Focus on protection of real economy

– Manage riskiness of collective behaviour

– Pay attention on linkages across entities

Why is it needed?

• Financial systems absorb risks but also create risks

• Tradeoff between risk absorption and risk creation

• Exposure and generation of common risks (Wolfe,2014)

– Same economic cycle

– Same funding markets

– Same accounting rules

– Same suppliers of insurance

– Same risk management models

– Same rating agencies

– Same regulatory standards

How should it be done?• Instruments

– Capital

– Regulatory capital

– Profit distribution rules

– Investment rules

– Collateral rules

– Disclosure

– Compensation schemes

– Resolution Plans

Financial Stability• Viewed through the concept of

systemic risk• Difficult to assess nature of crisis–short term driven by fear and

illiquidity?–long term driven by weak

fundamentals and insolvency?

• Difficult to delineate events, cause of event, impact of events

Financial Stability• Competing & contradictory definitions

with associated metrics–43 definitions (Eling & Pankoke, 2014)–‘’.. impairs the financial system where

economic growth and welfare suffer materially “ (ECB)

–Other definitions focus on specific mechanisms like imbalances, correlated exposures, spillovers to the real economy, information disruptions, feedback behaviour, asset bubbles, contagion

Financial Stability• Risk of disruption to financial services that is caused by

an impairment of part or all of the financial system andhas the potential to have serious negativeconsequences for the real economy

• Robustness of financial system to exogenous or endogenous shocks– Endogenous shock: sovereign default for life sector– Exogenous shock: reinsurance failure P&C sector

• Negative externality that no entity prices

• Systemic if “it’ poses harm to the real economy

Financial Stability

• Two dimensions

– Evolution of risk over time i.e. procyclicality

– Distribution of risk at a point in time i.e. contribution of each entity to systemic risk

• Limited theoretical and empirical knowledge of interaction between financial system and macro economy

Systemic Risk Measurement• 30 systemic risk measures (Bisias, Flood, Lo &

Valavanis ,2012)

• Balance Sheet and Market Indicators– Backward looking and micro in nature

• Early warning indicators– No reflection on how the real economy and

financial sector interact• VAR models

– Forward looking and tracks transmission of shocks• Macro stress tests

– Forward looking

Environmental Scan• Limited fiscal buffers

– Primary deficits– High debt stocks

• Limited external buffers– Balance of payments deficits– Low foreign reserves

• Growth barriers– Catastrophe prone– Low factor productivity– Unproductive rent seeking by special interest groups– Devaluation of institutions – Low will to engage in fiscal, debt and exchange rate

adjustment unless mandated by external party or crisis– Large off balance sheet age related and interest sensitive

liabilities for pensions and health

What We Say• Promotion of monetary, credit and exchange policies as would

foster financial stability and be favourable to the economy(TNT)

• Foster an economic and financial environment conducive tosustainable economic growth and development (Barbados)

• Formulate and implement monetary and regulatory policies tosafeguard domestic currency, ensure soundness anddevelopment of financial regulation (Jamaica)

• Regulate supervise securities, insurance and pensionindustries for protection of users (Jamaica)

• Maintain stability of dollar and integrity of banking system(OECS)

What We Do

• Pre Crisis Thinking

– Inflation targeting and micro prudential policy provides stability

• Micro level policy

– Limits distress of individual entities

• Capital standards

– Focuses on protection of investor & policyholder

– Manages riskiness of the entity’s behaviour

– Scant, if any, attention paid to linkages across entities

Insurance Models• Network theory, financial system is a network with

nodes and edges (Anand et al 2013)

– Two nodes, FIs and NFIs doing business with Fis– Edges or business activities

• Activities– Underwriting– Funding – Investing

• Traditional Activities have very low systemic risk(Cummins & Weiss 2011,2013; Grace et al,2013;Kessler, 2013;Park & Xie,2011)

– Risks reduce through law of large numbers– Low correlation between risks– Loss events have low correlation with business cycles– Orderly and long claims settlement

ActivitiesTraditional

• Pure hazards of death, disability, sickness, accident, fire, theft, catastrophe, legal, liability

• Asset liability management

• Liquidity management

Non Traditional• Both

– Short term funding– Securitisation– Securities Lending

• Life Insurance– Annuities– Universal Life– Mutual Funds– Deposit Administration Funds

• General Insurance– Reinsurance– Credit insurance– Financial guarantees– Insurance linked securities– Industry loss warranties– Credit default swaps

Main Actors (financial reports)

Guardian Sagicor Ansa NCB Republic CIBC Scotia RBC NIS UTC

Life insurance

Y Y Y Y N N Y N Y N

Generalinsurance

Y Y Y Y N N N N N N

Asset management

Y Y Y Y Y N Y Y Y Y

Investment banking

N Y Y Y Y Y Y Y N? N?

Commercial banking

N Y N Y Y Y Y Y N N

Multicountry

Y Y Y Y Y Y Y Y y N

NTActivities Y Y Y Y Y ? Y ? Y Y

Main Actors (financial reports)

Guardian Sagicor Ansa NCB Republic CIBC Scotia UTC

Equity 460 725 840 644 1,318 1,555 1,281 184

Assets 3,501 5,298 1,941 3,970 9,137 11,439 6,561 3,454

Leverage 13% 14% 43% 16% 14% 14% 20% 5%

NI assets 786 1,864 NA 2,146 3,618 1,034 2,180 269

NI Leverage 59% 39% NA 30% 36% 150% 59% 68%

Insurance FailuresEntity Size (USD) Cause

Equitable Life,UK 1.6 bn Guaranteed annuity rates

Lloyds,UK 16bn Asbestos,pollution

ING,Netherlands €10bn Sub prime mortgages

Hartford,US 5.9bn Variable annuities

AIG,US 182bn Credit default swaps,securities lending

HIH,Australia AUD 3.6-5.3bn Governance,mispricing

CLICO,BAICO ??? Governance, asset mismatch

Financialsector,Jamaica

$3bn,45% GDP Governance, asset mismatch

Identifying SIFIs(Financial Stability Board 2009)

• Size of exposures – Volume of transactions or total assets– Large entity or many small entities with same business models and

high correlations

• Interconnectedness– Degree of correlation and hence risk of contagion from a common

shock – Connected through sovereign debt

• Lack of substitutes– Services of entity are critical to functioning of markets or key actors in

the financial system– Indicators are barriers to entry and market shares

• Time (IAIS)

– Speed of loss transmission to third parties

Identifying SIFIs: Secondary Indicators• Leverage

– debt to equity or equity to asset ratios– Inclusion of off balance sheet items– Inclusion of margin facilities

• Complexity– Multi holding companies and subsidiaries– Multi country– Multi products and services– Complexity of products and services

• Regulatory Policy– Adverse incentives due to regulatory arbitrage– Procyclical capital requirements

• Liquidity Risk and ALM Mismatches– Market liquidity– Funding liquidity– Optionality in assets or liabilities

Industry Concerns

• Fiscal and monetary policy should not amplify risks

– Capital controls create a duty on policymakers to have responsible fiscal and monetary policies

– Pattern of debt restructurings, modes of intervention in failed entities, reluctance to chart paths quickly adds to uncertainty

• Disorderly resolution of systemic risks

Industry Concerns• Regulation should not amplify capital risks

– Capital controls compel entities to buy domestic assets

– Capital standards provide significant reward to buying sovereign bonds

– Recent debt restructurings have reduced supply and increased cost of capital

– Localisation of capital in regulations have created the need for more capital in markets with low growth prospects

– Tradeoff in capital required at micro and macro prudential level to avoid capital raising, market exit or socialisation of risk because of higher prices

Interconnectedness Data Set

• Classification– product– counterparty– maturity– credit rating (standard required for unrated)

• Size– Gross– net of collateral– fair value– Currency

• Potential capital calls by stressing net exposures• Concentration

Resolution Models

• Do nothing aka taxpayer bailouts

• Internalise systemic risk

• Manage systemic risk

Criteria for Resolution Models

• Transparency, Speed (weekend) and Certainty

– Identifying distressed entities

– Counterparty risk

– Illiquid assets

– Core Liability Management

• Suspension of termination rights

Resolution Models

• Internalise systemic risk

– Resolution fund

– price explicitly for taxpayer guarantee

– Risk premium is A+B

– A= expected losses of entity on default

– B=expected systemic costs in a crisis x contribution of the entity

Resolution Models

• Manage systemic risk – Stricter definition of Tier 1 Capital– Leverage limits– Living Will : tranches of debt converted into equity

until defaults are cured– Contingent Capital Notes– Contingent Capital Insurance– Liability Enhanced Equity– Regulatory Forbearance – Shotgun marriages

• More capital required

Path Forward• Unhealthy focus on micro rather than macro

prudential regulation despite mission statements

• Systemic data set required

• One regulatory model

• Agree to a definition of systemic risk across the Caribbean

• Identify SIFIs on a rational basis

Path Forward• Measure total systemic risk and contribution of

each entity

• Negotiate a tradeoff between required capital and capital for systemic risk so total capital is unaffected

• Governance must include industry experts and be cross border

• Each SIFI should have a predefined resolution model

• Regulatory forbearance should apply where fiscal metrics deviate significantly from planned

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