How insurers differ from banks: Implications for systemic regulation

Christian Thimann

Having completed the regulatory framework for systemically important banks, the Financial Stability Board is turning to insurance companies. The emerging framework for insurers closely resembles that for banks, culminating in the design and calibration of capital surcharges. This column argues that the contrasting business models and balance sheet structures of insurers and banks – and the different roles of capital, leverage, and risk absorption in the two sectors – mean that the banking model of capital cannot be applied to insurance. Tools other than capital surcharges may be more appropriate to address possible concerns of systemic risk.

Regulation of the insurance industry is entering a new era. The global regulatory community under the auspices of the Financial Stability Board (FSB) is contemplating regulatory standards for insurance groups that it deems to be of systemic importance. Nine insurance groups received this FSB classification in 2013, and the design of systemic regulation for these groups is now in progress.

The framework that the FSB has rolled out for systemically important insurers is virtually identical to its framework for systemically important banks (Table 1). The identification criteria are largely the same, and so are the envisaged policy measures: enhanced group-wide supervision, preparation of crisis management tools, and possibly higher capital charges for some activities (IAIS 2013a, 2013b).

Table 1. FSB framework for systemic banks and insurers compared

Source: FSB (2011, 2012, 2013), author’s compilation.

The current regulatory approach is not yet sufficiently taking account of the fact that insurance companies have a fundamentally different business model and interact with each other and the financial system in a way that is very different from banks. Prudential regulations for the two sectors (Basel III versus Solvency II or the US risk-based capital framework) are entirely different, and confirm the need to adapt rules to the fundamental differences between the two sectors.

Specifically, there are four main differences and two similarities between insurance and banking with regard to systemic interaction (Thimann 2014, Table 2).

Table 2. Banks and insurers: Differences and similarities with regard to systemic interaction

Differences between banks and insurers with regard to their systemic role

Institutional interconnectedness

The first key difference between banks and insurers with regard to systemic risk is that banks operate within a system, namely the banking system, while insurers do not. Banks are institutionally interconnected; they operate through direct balance sheet exposure to each other in the form of unsecured and secured interbank lending. The fact that there is a central bank is yet a further aspect that demonstrates the degree to which banks function, and can only function, within a system.

Insurers are not institutionally interconnected; they are stand-alone operators in institutional terms. There exists no ‘insurance system’, and no ‘central insurer’ comparable to a central bank. It is sometimes argued that insurers and reinsurers together constitute a system that resembles the banking system. But such a parallel overlooks the functions and size of reinsurers, which only take up portions of the primary risks of insurers. Munich Re has a balance sheet of €105 billion1 – a fraction of the balance sheets of the largest banks or central banks for that matter (Baur et al. 2003).

Maturity transformation

Banks engage in maturity transformation combined with leverage; they transform short-term liabilities into longer-term assets. Insurers do not engage in maturity transformation. They pursue a liability-driven investment approach, trying to match their asset profiles with their liability profiles. Since they are funded long-term, insurers are essentially ‘deep-pocket’ investors. This makes them react very differently to downward market pressure compared with a short-term funded or leveraged investor.

Liquidity risk

Liquidity risk is inherent in banking (Allen and Gale 2000), but not in insurance. Banks risk being liquidity-short; insurers are liquidity-rich. Deposits are the largest item on banks’ balance sheets. Hence, bank liabilities are predominantly short-term, withdrawable at will, and held exclusively by trust.

Insurance liabilities are less fugitive. The liabilities for insurance of general protection, property, casualty, and health are not callable at will. They relate to exogenous events that policyholders do not influence. The part of liabilities that are theoretically callable concerns those parts of life insurance business that are not annuities. But there are often penalties for early withdrawal, and tax benefits might vanish.

Money, credit, and payment function

Banks deal with the payment function, they create credit, and their liabilities constitute money. This means that they are a means of payment and provide a public good function in a market economy. For the Eurozone, the stock of money measured by M3 amounts to €9.9 trillion, of which 85% are bank deposits.

Insurers’ liabilities do not constitute money but represent an illiquid financial claim. Moreover, insurers do not provide essential financial market utilities and are less integrated into the financial market infrastructure. In particular, they are not an organisational part of the payments or settlement systems.

Figure 1. Banks and insurers: Stylised balance sheets and systemic linkages

Similarities between banks and insurers

The role as financial intermediaries

Just like banks, insurers are financial intermediaries as far as their life insurance business lines are concerned. Their liabilities represent financial claims for policyholders, and their assets are predominantly financial assets. Insurers collect savings, intermediate between savers and investors, channel funds, and fulfil a function of capital allocation in the economy. They are indeed important sources of funding for the real economy, also as a wide range of assets are eligible for them.

The role as investors

Just like banks, insurance companies are large investors in financial markets. They receive insurance premia against a promise to cover adverse events and carry savings forward. The premia are invested in a diversified portfolio of assets, encompassing government and private sector bonds, equities, loans, infrastructure finance, and other assets.

The roles of leverage, capital, and loss absorption capacity – and implications for systemic regulation of insurance

Leverage

The chief enemy of systemic risk control is leverage (D’Hulster 2009). Leverage is inherent in banking and quasi-absent in insurance. “Banking is all about leverage”, says Stefan Ingves, Chair of the Basel Committee for Bank Supervision. “Banks are highly leveraged financial institutions that are in the business of facilitating leverage for others” (Ingves 2014).

For insurers, the largest liability consists of policyholder reserves. Insurers do not raise debt to purchase financial assets to cover liabilities towards policyholders. They do so mainly to finance mergers and acquisitions, and to a lesser extent to establish a cash buffer if needed or to buy fixed assets (buildings etc.). For insurers, a leverage ratio would better not be defined as equity over assets (as for banks) but as equity over debt, or the inverse, which is often referred to as the gearing ratio.2

This difference has major implications for regulation. For banks, capital surcharges can actually control leverage because they slow down asset acquisition, also by slowing credit growth; this is the process of deleveraging. Insurers can reduce the debt gearing but they cannot reduce their insurance assets because this would imply cancelling insurance contracts with existing policyholders, which is generally not allowed.

The role of capital

The linchpin of bank systemic regulation is capital. In addition to restraining leverage, higher capital charges for banks raise the costs of balance sheet growth and augment the immediate loss absorption capacity of individual institutions to shocks, which in turn limits the pass-through of such shocks to the system (Acharya et al. 2010).

To the extent that liquidity risks are beginning to materialise, banking capital can help stem an initial outflow by helping to tap market funding or central bank recourse, for which sufficient capital levels are a precondition. While robust capital levels do not protect depositors directly, they can be seen as providing a first protection against deposit outflows or other liquidity shortages.

In insurance, capital has a very different role (Plantin and Rochet 2007). It serves essentially to ensure that the last policyholder gets paid. First all assets are wound down, which typically can take many years,3 and to be sure that there enough assets to cover eventually all liabilities also under adverse market conditions, regulators demand more assets than liabilities from the outset, which is what establishes capital.

Hence, whereas in banking, capital enters the sequence of adverse events at the beginning, in insurance it enters the sequence of adverse events at the end. This difference has an important implication for systemic regulation because it changes the effectiveness of capital surcharges. Raising capital levels for banks increases their buffer to withstand shocks and therefore helps avoid that a chain of systemic contagion unravels. Raising capital for insurers, in contrast, essentially means that there are (even) more assets available to cover the liability stream than otherwise, but has no crisis prevention or stabilisation function.

Loss absorption capacity

There is a third factor that has a bearing on the absorption of systemic risk, and which this time is specific for insurance. For banks, the loss absorbency on the liability side is mostly confined to the equity tranche. There have been recent market and regulatory initiatives to raise the degree of loss absorption through debt contracts converting into equity (conditional convertibles) and through the formalisation of bail-in rules allowing for the write-down of subordinated debt, but these efforts remain limited in scope.

In insurance, the bail-in is built in – there is an inherent loss absorption capacity in the form of beneficiary participation in a significant part of life insurance contracts. In these contracts policyholders participate in the gains and losses of the investments linked to their policies. Hence, there is a built-in loss absorbency function in insurance on top of the equity tranche.

Conclusion

Banks are often seen as the archetypal financial institutions and hence oversight of systemic risk in the financial system naturally starts from the banking model. This is further justified as banks represent the core of the financial system (with the central bank at its heart) and as banks operate within a closely interlinked banking system where contagion and systemic risks are prevalent.

When regulators seek to capture possible sources of systemic risks in types of financial institutions other than banks, such as large insurers, it is necessary to adapt the systemic regulatory framework appropriately (Elliott 2013, Zigrand 2014). The far-reaching differences in the two prudential frameworks – Solvency II for insurers and Basel III for banks – are a clear indication of the far-reaching differences between the two business models.

This column has underlined the differences and similarities between insurers and banks with regard to systemic interaction. The comprehensive systemic risk study by the US Treasury’s Office of Financial Research stresses the importance of ‘four Ls’ in systemic crises: linkages, liquidity, leverage, and losses (Bisias et al. 2012). As shown in this column, these four issues need to be conceived in a fundamentally different way for insurance than they are for banking.

As a direct consequence, capital surcharges may not be the right tool to deal with concerns about systemic risk in insurance. In case certain activities give rise to systemic risk, regulatory responses other than capital surcharges may be more appropriate (ranging from investment limits, changes to the design of insurance contracts, or guidelines on how more complex contracts should be managed).

References

Acharya, V, L Pedersen, T Philippon, and M Richardson (2010), “Measuring Systemic Risk”, New York University Working Paper.

Allen, F and D Gale (2000), “Financial Contagion”, Journal of Political Economy 108: 1–33.

Baur P, R Enz, and A Zanetti (2003), “Reinsurance – A Systemic Risk?”, Zurich Re.

Bisias D, M Flood, A Lo, and S Valavanis (2012), “A Survey of Systemic Risk Analytics”, US Office of Financial Research Working Paper 0001, 5 January.

D’Hulster, K (2009), “The Leverage Ratio”, World Bank Financial and Private Sector Development Note 11, December.

Elliott, D (2013), “Regulating Systemically Important Financial Institutions that are Not Banks”, Brookings Institution Paper, 9 May.

Financial Stability Board (2009), “Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations”, Report to the G-20 Finance Ministers and Central Bank Governors, October.

Financial Stability Board (2011), “Policy Measures to Address Systemically Important Financial Institutions”, 4 November.

Financial Stability Board (2012), “Update of Group of Global Systemically Important Banks”, 1 November.

Financial Stability Board (2013), “Global systemically important insurers (G-SIIs) and the policy measures that will apply to them”, 18 July.

IAIS (International Association of Insurance Supervisors) (2013a), “IAIS Commits to Develop by 2016 a Global Insurance Capital Standard”, Press release, 9 October.

IAIS (International Association of Insurance Supervisors) (2013b), “Basic Capital Requirements for Global Systemically Important Insurers (G-SIIs): Proposal”, 16 December.

Ingves, S (2014), “Banking on Leverage”, Keynote address, Bank for International Settlements, 25 February.

Plantin, G and J-C Rochet (2007), When Insurers Go Bust: An Economic Analysis of the Role and Design of Prudential Regulation, Princeton University Press.

Thimann, C (2014), “How Insurers Differ from Banks: A Primer in Systemic Regulation”, LSE Systemic Risk Centre Special Paper 3, July.

Zigrand, J-P (2014), “Systems and Systemic Risk in Finance and Economics”, LSE Systemic Risk Centre Special Paper 1, January.

Footnotes

This is the balance sheet value of reinsurance activities, excluding Munich Re’s primary insurer Ergo.

2 In the same vein, rating agencies measure the leverage of insurers by dividing their debt by their equity and by comparing their debt to their pre-tax earnings.

3 UK Equitable, for example, had to be wound down and has been in runoff for years. Policyholders are served from the asset pool just as if the insurance company was active.