INSURANCE, SYSTEMIC RISK & THE FINANCIAL CRISIS Faisal Baluch, Chris Parsons & Stanley Mutenga

1. INSURANCE, SYSTEMIC RISK & THE FINANCIAL CRISIS Faisal Baluch, Chris Parsons & Stanley Mutenga Cass Business School, City of London 1

2. AIMS OF THE PAPER A broad assessment of the impact of the Financial Crisis on the insurance sector Evaluation of systemic risk in insurance 2

3. GENEVA ASSOCIATION RESEARCH ‘Systemic risk in insurance – an analysis of insurance and financial stability’ (March 2010) Key findings No systemic risk from insurers’ core activities Insurance business model a source of stability, not the reverse 3

4. TOPICS 1 Historic insurance ‘crises’ 2 Effect of the Crisis on insurance risk 3 Effect of the Crisis on insurers’ performance 4 Systemic risk in insurance 4

5. HISTORIC INSURANCE ‘CRISES’ ‘Crisis’ implies the failure of many insurance firms and/or failure in the supply of insurance, leading to economic disruption Examples: 1984-6 US liability insurance crisis 1976-7 product liability crisis lack of terrorism cover post 9/11 Lloyd’s near-collapse 1988-92 5

6. INSURANCE ‘CRISES’  Typically short, local and limited in their effects  Never a world-wide ‘insurance crunch’ 6

7. LESSONS FROM HISTORY 1 - LOYD’S CRISIS 1988-92  Massive losses – mainly on US liability business (asbestos, pollution, med-mal)  ‘Names’ (investors) pulled out so capital disappeared  Lloyd’s mired in litigation  The LMX reinsurance ‘spiral’ (syndicates ABC reinsure with CDE, which reinsure with FGH, which reinsure with IJK, which reinsure with ABC, which reinsure with CDE … etc …etc) 7

8. LESSONS FROM HISTORY 1 - LOYD’S TODAY  Lloyd’s came through the Crisis almost unscathed  Has focused on core insurance business and risks it understands  Very little exposure to equity markets 8

9. EFFECT OF THE CRISIS ON INSURANCE RISK  Recession has dampened demand for some lines of insurance  Life insurers most affected in Western markets  Non-life insurers seeing higher levels of insurance fraud  Some lines of insurance are especially sensitive to a financial crisis/recession – e.g. liability insurance and insurance involving credit risk 9

10. LIABILITY INSURANCE  Lines most affected are Errors and Omissions (E&O) and Directors and Officers insurance (D&O)  Estimated losses US$9.6bn, ($5.9bn for D&O, $3.7bn for E&O (Advisen, 2008)  This is long tail business, so final cost will not be known for many years  AIG is the market leader – writes 35% of D&O 10

11. UNDERWRITING OF CREDIT RISK BY INSURERS  Various lines of insurance cover some credit risk, e.g. Payment Protection Insurance (PPI) and Mortgage Protection Insurance (MPI)  Most important is credit insurance- covers losses made by firms whose customers fail to pay for goods or services provided (usually owing to insolvency)  Market leaders (e.g. Euler Hermes) have taken big losses and supply has diminished – this has affected trade and deepened the recession to some extent 11

12. LESSONS FROM HISTORY 2 CUTHBERT HEATH’S ‘EIGHT COMMANDMENTS’ ON CREDIT INSURANCE 1. ‘Credit insurance should be concerned with credit risks for goods sold and delivered by merchants and manufacturers to their customers on credit terms in the normal course of business.’ 8. ‘Financial credits such as loans by banks or finance houses should not be insured.’ 12

14. WHICH WERE THE BIG INSURANCE LOSERS?  Specialist financial guarantee insurers (e.g. US monolines)  Companies which dabbled in risky areas of structured finance (e.g. AIG and Swiss Re)  Firms writing business which is sensitive to an economic downturn (e.g. credit and liability insurers)  ‘Bancassurers’ – integrated financial services providers and insurers having close affiliations with banks  Insurance firms holding a high proportion of risky assets (some US life insurers especially) 14

15. EFFECT ON INSURANCE MARKET STRUCTURE  Some insurers needing to raise fresh capital  Smaller/weaker firms vulnerable to M&A activity  Insurers will re-focus on core business strengths to conserve capital and reduce risk  ‘Bancassurance’ models are called into question – few benefits for insurers in the current climate? 15

16. REGULATION  Stronger regulation of banking sector inevitable – will it spill over to insurance sector?  Current capital adequacy regimes (e.g. EU Solvency II project) believed to be sufficient  Regulators may seek to re-impose laws which separate banking, securities/investment and insurance  Tighter regulation of some (non-regulated) financial products – e.g. Credit Default Swaps  Need for harmonisation of guarantee funds in insurance, banking and securities 16

17. BRITISH BANKERS APOLOGISE FOR THE FINANCIAL CRISIS …. (A LITTLE) Read more: http://

19. 19

20. 20

21. SYSTEMIC RISK IN INSURANCE  Money cannot be withdrawn from an insurer on demand – so no ‘run on the insurer’  Insurers’ liabilities arise mainly from localised and non- correlated perils (fires, crashes, storms, negligence suits) – these can be diversified quite easily across the globe  Insurers do not trade with each other extensively – though reinsurance is an exception 21

22. SYSTEMIC RISK A financial phenomenon that causes widespread downturn in economic regions and industry sectors. It is derived in two ways: 1 Micro Systemic Risk: Financial contagion as a result of multitude of events leading to a chain reaction (Spill-over/Domino effect). 2 Macro Systemic Risk: Financial contagion as a result of simultaneous impact by a single event (i.e. downturn in the US residential market).

23. SYSTEMIC RISK IN THE INSURANCE AND BANKING SECTORS Traditional levels of systemic risk Banking Sector: Strong form Insurance Sector: Weak form Current levels of systemic risk Banking Sector: Strong form Insurance Sector: Semi-strong form 23

24. WHAT HAS CHANGED? • Expansion of bancassurance • Insurers big players in the derivative market (namely CDS) • Insurers and banks connected via funding channel (Capital Market)

25. CREDIT DEFAULT SWAPS (CDS)  Global market volume for CDS just USD 1.189 Trillion in 2001. Sellers included US ‘monoline’ (financial guarantee) insurers and reinsurers (market share 20%) and primary insurers (13% share) – 33% in total  Insurers’ share now down to about 17% - but market for CDS has grown to around US$60 Trillion  Big ‘insurance’ losers on CDS include US monolines (e.g. AMBAC, MBIA, CIFG Guaranty), Swiss Re, AIG  AIG’s mainstream insurance business relatively sound  CDS not ‘insurance’ for regulatory purposes – much of the market for CDS has been unregulated posing CDA risk 25

26. REINSURANCE AS A FORM OF SYSTEMIC RISK The sector faces the following risks via Reinsurance • Credit Risk - Possibility of default by Reinsurer • Systemic Risk - Caused by the linkage between Reinsurance market and the capital markets (potential for micro-systemic risk) What is the likelihood of Systemic Risk via the Reinsurance sector? • No historical large scale default of any Reinsurer • Insurers diversify pure risk to various Reinsurers thus reducing concentrated credit risk exposure • Retrocession helps diversify risk further

27. REASONS FOR INSURANCE COMPANY FAILURE (US PROPERTY/CASUALTY) 1969 - 2005 Source: A.M. Best

28. HOWEVER …. • Reinsurers are active participants in the capital markets • Their involvement in the derivative market strengthens the micro systemic link with the banking sector and thus could pose contagion through to the insurance sector

29. CHANGES TO COME AS A RESULT OF THE RECENT SYSTEMIC CRISIS • Bancassurance model change - Spin-offs between banking and insurance divisions • Regulatory changes to tighten controls on insurer capital holding requirements • Insurers to curb involvement in the derivatives market

30. CHANGES TO COME AS A RESULT OF THE RECENT SYSTEMIC CRISIS Even with such changes, the insurance sector remains exposed to Systemic Risk. Developments over the last decade have lead to a move away from the traditional insurance business model and greater linkages with other financial sectors. This seems likely to continue, given the increasing array and magnitude of risks that require diversification