Systemic risk management:Implications for insurers

Anthony Bice and Jacob Hook Oliver Wyman

Section 1

What is systemic risk and how are policy makers responding to it?

We think of systemic risk as the risk of the financialsystem not being able to fulfil its critical functions

Components of the financial system

• Institutions, in particular banks, insurers, securities firms, institutional investors, specialty finance companies, etc.

• Financial infrastructure, in particular legal, payment, settlement, and accountancy systems

• Financial markets, in particular stock, bond, money and derivative markets

Critical functions of the financial system

• Allocates resources between different activities and across time

• Facilitates maturity transformationbetween lenders and borrowers with diverging preferences

• Provides pricing and management of economic and financial risk

• Enables efficient transactions through payment systems

Systemic risk typically involves failure of one part of the system having negative externalities for other parts of it, and the real economy

Systemic risk can take on a broad range of forms

Institutions

• Financial risks– Credit– Market– Liquidity– Interest rate– Currency

• Non-financial risks– Operational – Legal– Reputational– Business

• Concentration risk

• Capital adequacy risk

• Clearance/payment/ settlement system risk

• Infrastructure short-comings– Legal– Regulatory– Accounting– Supervisory

• Technology

• Loss of confidence

• Domino effects

Infrastructure Markets

• Counterparty risk• Asset price misalignment

• Run on markets– Credit– Liquidity

• Contagion

Relevant institutions include banks, insurers, re-insurers, monolines, investment banks, private pools of capital (hedge funds and private equity), public pools of capital (asset managers and pension funds), financing companies (retail and corporate), non-financial institutions, sovereign funds

Many of the key systemic risks are now on the regulatory agenda –but some have still received insufficient attention

Being addressed Not sufficiently addressed Not broadly discussedInstitutions • Capital

– Arbitrage– Tier 1 composition– Pro-cyclarity

• Liquidity risk underestimated

• Incentive structures not risk aligned

• Conglomerate interconnectedness

• NBFI maturity transformation

• Non-financial institutions’ lending and trading activities

• Country risk concentrations• Under-funded pension

funds

Infrastructure • Systematic overreliance on unregulated rating agencies– Conflict of interests– Quality of methodologies

• Fair value accounting –pro-cyclical impact

• Ownership and soundness of critical infrastructure

• Outsourcing and off-shoring

• Legal framework for post-default processes

Markets • Oversight of CDS and otherOTC markets– Central clearing– Trade reporting

• Treatment of new classes of products

• Asset price bubbles

Source: Oliver Wyman analysis

Beyond addressing specific risks, the policy community also needs to improve its ability to monitor and respond to risks across the system as a whole

National level response

• Establishment of systemic risk policy functions:

– Explicit remit to assess threats to systemic stability

– Proximity to central bank capabilities

– Effective engagement with prudential supervisors

• Increased integration of micro-prudential regulation

– Across FS industries

– Including ‘unregulated’ sector

International early warning systems

• Micro-data framework agreements

• Data gathering processes

• Data analysis function

• Policy response function

• Monitoring of country level policy implementation

• Oversight of national regulator effectiveness

Partial progress by most countriesto date

Technical work underway by FSB/IMF, unclearpolitical will to support at national level

A key issue for insurers in the application of theregulations is the definition of systemic importance

• Being defined as systemically important will have significant (generally negative) implications for a financial institution:– Differentiated treatment in a crisis– Potentially differentiated capital requirements– More significant business model restrictions– Greater scrutiny and oversight

• The Financial Stability Board and other public bodies are investing significant effort into developing working definitions for systemic relevance

• Much of this work is highly bank focused and risks overlooking the very different nature of the insurance/wealth business

Insurance and wealth players will need to engage with regulators on the definition and implications of systemic relevance

Section 2

Financial Stability Board approach to systemic risk and relevance for

insurance and wealth

FSB and IAIS have set out a number of criteria for measuring the“systemic importance” of a financial institution or sector

Size• The volume of financial services provided by the individual component of the financial system

1

Substitutability• The extent to which other components of the system can provide the same services in the extent of failure

2

Interconnectedness• Linkages with other components of the system

3

Timing (additional factor suggested by IAIS)• Timeframe over which financial impact of events is transmitted through to cash flow and balance sheet

Other contributing factors4

• Liquidity and large mismatches– ability to roll-over funding without need to liquidate large holdings

• Complexity – a complex institution is more prone to information asymmetries and have poorly monitored exposures

FSB/IAIS criteria for assessing systemic importance

• Leverage – impact of small price movements on the capital base

FSB is said to have compiled a list of 30 “systemically important” financial institutions including 5 global (re)insurers

5

No natural or man-made catastrophe loss has ever reached the losses caused by defaulted Lehmann debt or by the banks’ writedowns during the recent crisis

FSB/IAIS criteria – Size

Insured catastrophe losses 1970-2008(in USD BN, indexed to 2008)

Source: Sigma 02/2009, Sw iss Re 2009; Oliver Wyman analysis

0

20

40

60

80

100

120

140

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Earthquake/tsunami Man-made disasters Weather-related Nat Cats

Total insurance losses

Hurricane Andrew

Winter storm Lothar

Attack on WTC

Northridge earthquake

Hurricane Ike, GustavHurricane

Katrina et alHurricanes Ivan, Charley

et al

Global Banks’write-downs 2007-09

1,700 BN

Lehmann outstanding debt at default

155 BN

Although natural and man-made catastrophes are growing more frequent and intense they are not nearly large enough to cause systemic risk

Typically, a large insurer/wealth manager is much more diversified than a similar bank: so the size of an institution’s balance sheet alone is a poor indicator

FSB/IAIS criteria – Size

Breakdown of Economic Capital for European banks and insurers

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%

CommercialBanking

RetailBanking

Sales &Trading

AssetManagement

Life/Wealth P&CInsurance

Reinsurance

Credit MarketLife insurance P&C InsuranceBusiness OperationalOther

Financial risks

Non-financial risks

• Insurers are exposed to a combination of risks in different geographies…– Credit and market risks– Insurance risks– Other risks

• …while banks’ activities, whether retail or commercial banks, are mostly concentrated on credit risk and, to a lesser extent, market risk

• Insurers’ risks are generally less correlated than banks’ risks, e.g.– Mortality/longevity vs. market risks– P&C/cat risk vs. market risks

• Composite insurers achieve a diversified risk profile by combining– P&C insurance business– Life insurance business– Asset management – Retail banking activities

• Reinsurers’ business model is driven by diversification of nat cat exposures in terms of risks and geographies

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

Reinsurance capacity has always reappeared after natural catastrophesHence insurance capacity is highly substitutable

FSB/IAIS criteria – Substitutability

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

Year

US$B

N

0

50

100

150

200

250

300

350

400

450

RoL Index (1990=100)

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

New capital flows into nat cat reinsurance and nat cat reinsurance rates

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

• Reinsurance rates increases for years following big catastrophes

• This attracts steady inflow of capital in the industry through new entrants or capital increases of existing reinsurers– Including side cars and cat

bonds• In addition, capital base of

reinsurers is also progressively rebuilt after large natural catastrophes through the higher reinsurance rates

No data on inflows

1990-1993

Hurricane Andrew

9/11 Hurricane Katrina

Insurance capacity is highly substitutable if the underlying event is insurable

The Eurozone PIIGS crisis is the latest example of the perils of interconnectedness

FSB/IAIS criteria – Interconnectedness

Source: BIS, New York Times; Charlotte’s Web

Through their various activities, insurers and wealth managers are linked to many components of the financial system

FSB/IAIS criteria – Interconnectedness

Inter-connections of key risk activities in which insurers are engaged

Liability OriginationActivities

Policyholders

Reinsurers

Retrocessionaires

Insurance linked securities market

Bond market

Equity markets

Derivative market

Derivative counterparties

Commercial paper market

Stock lending counterparties

Selling credit protectionE

Asset ManagementActivities

A B

Capital, funding liquidity

managementD

Ceding companies

Shareholders/debt holders

Risk-transferactivities

C

Connections to financial system

Connections to (re-)insurance industry

Connections to real economy

Source: Oliver Wyman Assessment

The CDS and reinsurance markets are both interconnected but the balance-sheet importance is of a different order of magnitude

FSB/IAIS criteria – Interconnectedness

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Insurance Reinsurance Retrocessions

$BN,

200

8

InsuranceLow level of business ceded by insurers, based on gross written premiums, USD 2008

Source: Sw iss Re sigma, IAIS Global Reinsurance Market Report 2009, BIS, Oliver Wyman analyses

BankingBanks transact significant CDS amounts among themselves

4,218

159 60

Life insurance Non-life insurance

1,782

2,436

2.4% 5.6%

55% 28%19,184

36,046

88,400

515

15,347

0

20,000

40,000

60,000

80,000

100,000

1,00

0 la

rges

tba

nks

asse

ts

Tota

l CD

Sou

tsta

ndin

gs

Rep

ortin

gde

aler

s

Ban

ks a

ndse

curit

ies

firm

s

Oth

ers

$BN,

200

8

95% of single name CDS outstandings

transacted between banks

CDS notional exposures represent ~41 % of worldwide banking assets (high proportion due to synthetic format of CDS that allows leveraging of notional exposures)

During the crisis some insurers did hit problems, especially where they were part of institutions with large banking or credit operations

FSB/IAIS criteria – Other contributing factors

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

Type 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

Credit Monoliners

• “Insurance companies” selling only credit insurance – highly leveraged and concentrated on US public and structured finance

• Some examples of exposure to US housing market leading to State intervention

• Not clear if these posed a systemic threat

• Problems in banking operations easily sufficient to overwhelm total conglomerate

• Insurance bal. sheet ring-fenced

• Severe problems in wholesale credit operations unconnected to insurance balance sheet

• Clear systemic threat

• Severe losses led to questioning of business model in general (AMBAC, MBIA)

Charac-teristics

$8 BN $40 BN $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

AIG was brought down by its Financial Products arm, which hid huge risk positions that went unnoticed due to inadequate regulation

Total State support $180 BN

FSB/IAIS criteria – Other contributing factors

Asset Mgmt.5%

AIG FP3%

US Life &Retirement

15%

Foreign Life& Retirement

28%US General

Ins.32%

ForeignGeneral Ins.

11%

FinancialServices

w /o AIGFP6%

AIG 2005 revenues by business lines¹

Sources: AIG Annual Report 2005, CIA World Fact Book, Testimony to the United States Senate Committee on Banking by Superintendent Eric Dinallo of the New York State Insurance Department, Testimony to the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises by Insurance Commissioner Joel Ario of the Pennsylvania State Department1: 2005 revenues show n at the peak of AIG FP – loss generating thereafter

• AIG FP was founded in 1987 as AIG’s capital markets division based in London– It avoided UK regulation as AIG holding was registered with

an equivalent US regulator: the Office of Thrift Supervision (OTS)

– After this AIG FP operated effectively unregulated– OTS supervised AIG FP in the course of assuring integrity of

the thrift within the holding but failed to draw the right conclusions

• AIG FP marginally contributed to AIG revenues • As of Sept. 2008, AIG FP portfolio had $2.7 TN of derivatives

notional– Concentrated on US housing market and corporate

CDOs/CLOs– $440 BN CDS exposure guaranteed by AIG holding

• AIG fall began in 2007– 2007: downgrades of US subprime securities, AIG’s CDS

counterparties request cash collateral – Sept. 08: AIG’s downgrade is announced, triggering further

cash collateral calls on CDS contracts and securities lending programme

– Unable to meet liquidity need, AIG is bailed out on Sept. 18th• As of 2009, AIG had received a total $182 BN of governmental

support, of which $129 BN is still outstanding

AIG FP vs. AIG revenues 2003-2008

-80

-40

0

40

80

120

160

2003 2004 2005 2006 2007 2008

Rev

enue

s (in

$B

N)

AIG FP AIG w /o FP

Insurance/wealth also differs from banking in the timing of activities – banking events happen with enormous speed whereas insurance events are rather slow

FSB/IAIS criteria – Timing

Timing of World Trade Centre Insurance ClaimsCumulative proportion of claims made

Friends Provident cash-flow disclosureSurplus emerges over 30+ years

The timing of insurance claims settlements reduces the risk of contagion as insurers are not exposed to sudden liquidity crunches

Source: Friends Provident, Reinsurance Association of America, Catastrophe Loss Development Study, 2008

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1 4 7 10 13 16 19 22 25

Quarter after 11 Sept 2001

% o

f tot

al n

et c

laim

pai

d

0

100

200

300

400

500

600

700

800

1-5 6-10 11-15 16-20 21-25 26-30 31-35 36-40 41+

5-year period

Surp

lus

emer

ging

With profits fund Protection InvestmentsPensions Annuities UK other

In summary, although the FSB criteria are relevant to determine systemic risk, we need to consider them at a risk activity level – insurers get a mixed scorecard

FSB/IAIS criteria for assessing systemic relevance

Size • Size is often an advantage in insurance as it allows a better pooling of risks across individuals and risks• Rather than size, it is therefore more relevant to look at the risk of insurers’ activities

1

Interconnectedness• Some (re)-insurers are inter-connected with other financial institutions for their investments and risk management• Intra-connectedness of insurance activities and operations within a group differ from those in banks

3

Substitutability• Only limited number of unique service or product offerings by one market participant that cannot be provided quickly

by other market participants in case of disruption. Unique offerings tend to be too small to have systemic impact • Risk-bearing and price-clearing capacity of the insurance sector does not suffer from non-substitutability

2

Timing• The activities in which insurers (insurance, asset management, derivatives trading, reinsurance and funding and

treasury activity) are engaged show different timing in transactions and liquidity constraints from banking

5

Other contributing factors• Leverage – not as relevant

for insurance/wealth

4

• Complexity and opacity given for some groups but by itself not a systemic risk

• Liquidity and large mismatches only of limited relevance for insurance/wealth

Section 3

Implications for insurers and wealth managers

Overall there are a number of activities that could contribute to a wider systemic problem, many of which are non-core and possibly under-scrutinised

• Hedging with derivatives

• ALM/Strategic Asset Allocation• Derivatives activities

• Catastrophic losses (nat cat,man-made cat and pandemic)

• Systematic under-reserving• Excess lapses on life business• Un-hedged embedded guarantees

Treasury-related activities

Long-term capital raising

• Credit insurance• Financial Guarantees• CDS writing

A B

E

Asset management Liability origination

Bus

ines

sac

tiviti

es

Ris

k tra

nsfe

r and

bala

nce

shee

t m

anag

emen

t

Source: Oliver Wyman Assessment

However most of these are “one-way” impacts – insurers could be the victims of another systemic crisis but are unlikely to be the cause

• Reinsurance/retrocession• Insurance linked securities and

insurance derivatives A

D

Risk management functions need to look beyond the core risks in the core businesses and understand what external factors could drive losses

• Global/macro risk scenario analysis to determine interconnectedness with other financial markets, with particular focus on the impact of broader FS reform– Likelihood– Impact– Timing– Risk management responses

• Deepen understanding of all business lines to understand which could cause disproportionate losses– In particular are there small or non-core businesses that have not been analysed from a

risk perspective• Clearly articulated capital/liquidity strategy including allowance for contingencies• Comprehensive risk appetite statement ensuring that all risks are acknowledged and

accepted – even if they can’t be managed• Engage in the regulatory process to ensure that the voice of the industry is heard

– Don’t be mis-regulated by default