ESRB Insurance Report

Annex 3 Sources of systemic risks 1. Introduction 6 1.1. Introduction and context 6 1.2. Definition of systemic risk 7 2. Literature review and cases of failure of insurers 7 3. What circumstances lead insurers to contribute to or cause financial distress? 8 3.1. Insurance contributing to financial distress due to external shocks 9 3.2. Disruptions in the financial system resulting from insurance activities 18 3.3. Double hit 25 3.4. Factors amplifying the size of the disruption 28 3.5. Conclusions 34 4. How can disruption and the behaviour of insurers affect the real economy or the financial system? 35 4.1. Economic activity by firms 35 4.2. Welfare of households and economic functions 39 4.3. Investment 43 4.4. Insurers as providers of liquidity and as counterparties of derivatives 50 4.5. Non-insurance and non-traditional activities 53 4.6. Conclusions 56 5. What could reduce the size of the impact? 58 5.1. Recovery and resolution 58 5.2. Insurance Guarantee Schemes 61 5.3. Collateralisation 66 5.4. Conclusion 67 6. Summary conclusions 68 Addendum 1 Categorisation of insurers’ activities 72 Addendum 2 Literature review – overview 73 Addendum 3 Case studies 81 Addendum 4 Non-life insurance concentration by country (un-weighted average) 86 ESRB Report on systemic risks in the EU insurance sector / December 2015 Annex 3 Sources of systemic risks 1 Addendum 5 Public interventions in the EU insurance sector 88 ESRB Report on systemic risks in the EU insurance sector / December 2015 Annex 3 Sources of systemic risks 2 Summary 1. Insurance, when properly functioning, contributes to financial stability. Insurers can be a valuable provider of stable long-term finance and services which benefit the real economy by allowing the transfer and efficient management of risk. However, under certain circumstances the insurance sector may also be a potential source of systemic risk. 2. The impact of disruptions in the insurance sector may take two main routes: first, where insurers cause a direct impact on the real economy, and second, where insurers cause an impact on the rest of the financial system. The more the distress of insurance and the distress of the rest of the financial markets happen simultaneously, the likelier it is that the damage to the real economy will be substantial. Both the risks arising in a “gone concern” situation (i.e. failure), and those in a “going concern” (i.e. impacts via the behaviour of insurers whilst in business) are considered. 3. Four key scenarios are identified as potential sources of systemic risk. • First, involvement in non-traditional, non-insurance (NTNI) activities, such as certain guaranteed returns and the writing of speculative derivatives, exposes insurers to financial risks. This involves maturity and liquidity transformation as well as leverage. Financial risks tend to be highly correlated in a crisis, so that (1) NTNI activities incur larger than expected losses across insurers and (2) NTNI activities incur losses at the same time as distress in financial markets. Furthermore, NTNI activities increase the probability of pro-cyclical behaviour by insurers as they increase insurers’ exposure both to financial market conditions and to liquidity risk. In addition, most NTNI activities also have a greater impact on the economy because of their interconnectedness with the rest of the financial system. • Second, the potential for pro-cyclical behaviour which can amplify financial market or real economy cycles, booms or stresses, taking the form of: • pro-cyclicality in asset allocation in up- and downturns, particularly in downturns, driven by various factors such as the use of benchmarks or the common reassessment of risk appetite (portfolio reallocation); • pro-cyclicality in some types of insurance provision, in particular where the risks being underwritten move with financial market conditions or the real economy. One example is trade credit insurance. • Third, as noted repeatedly by EIOPA, the ESRB and market analysts, scenarios involving multiple failures may be the result of common vulnerabilities to asset stresses and simultaneous prolonged low interest rates (i.e. the risk of a double hit). The EIOPA 2014 stress test shows that EU life insurers are vulnerable to this risk due to rigid guaranteed returns and maturity mismatches. Multiple failures of life insurers may impose losses on households and may result in asset fire sales by insurers, disruption to securities lending and derivatives markets, or even government bailouts. Preventive measures have been taken to mitigate the risks arising from prolonged low interest rates and the effects of these still need to be monitored. • Fourth, aggressive pricing and uncontrolled growth are factors that might endanger the continuity of insurance coverage provision by driving competitors out of business and diminishing the natural substitutability across the different providers of insurance coverage. Aggressive pricing might lead to under-reserving building up unnoticed over time. When a failure finally occurs, there are potentially no competitors to ensure the continuity of insurance coverage provision (as in the case of HIH Australia). ESRB Report on systemic risks in the EU insurance sector / December 2015 Annex 3 Sources of systemic risks 3 4. Whilst not currently identified as severe a risk as those discussed above, a material disruption to particular classes of commercial insurance could have a significant impact on real economic activity. Such classes include marine, aviation and transport (MAT) insurance, general and specific liability insurance and, in some cases, property insurance. Loss of cover in these areas is particularly critical where lenders require insurance e.g. commercial property, and for some economic activities, such as aviation or construction, insurance is mandatory – without it such activities might have to cease altogether. There are some specific markets where concentration is high, although the speed at which new capital can enter the market (contestability) may additionally mitigate the risks of a lack of substitutability. 5. In addition, there are several empirical cases where inappropriate management and/or ineffective micro-prudential supervision have led to the building up of risks on the asset side (asset concentrations) or the liability side (accumulation risks). However, such issues seem to have led at worst to idiosyncratic defaults (Executive Life, Chester Street, Western Pacific, Mannheimer Leben), without causing major concern from a macro-prudential perspective. 6. Recovery and resolution schemes help mitigate the impacts of failures, and insurance guarantee schemes provide compensation to policyholders, thus contributing to stability. However, due to limitations in coverage, nature and size, the current national schemes might be inadequate in the event of multiple failures or the failure of a large life insurer. This may undermine confidence in these schemes and impose costs on policyholders and society in general through bailouts. 7. Further, this paper does not assess the ability of existing and forthcoming micro-prudential supervisory instruments to tackle the risks identified here. This assessment will be undertaken as part of the Group’s work on macro-prudential policies and instruments that deal with such risks. ESRB Report on systemic risks in the EU insurance sector / December 2015 Annex 3 Sources of systemic risks 4 The table 1 below summarises the scenarios discussed above. Table 1 Scenario Cause of disruption Vulnerabilities/factors increasing scale of disruption Impacts on system and real economy NTNI Financial market downturn Correlated and larger-than-expected losses during financial market Liquidation of assets to cover losses (“fire sales”) crises Losses potentially affecting policyholder claims Liquidity pressures Losses spread to the financial markets due to failure to service liabilities from credit, securities lending or derivatives Pro-cyclicality: Price rises in assets Search for yield likely to be exacerbated by the pro-cyclical writing of Mispricing of risk amplifying upturns Low volatility some guarantees Amplification of bubbles/stresses Common behaviour driven by common assets and liabilities Amplification of credit cycle Use of asset managers, benchmarks and mechanical allocation rules Others’ balance sheets Potential regulatory and valuation features Collateral values and calls Uncertainty Wealth effects Firm funding costs Pro-cyclicality: Asset price falls Massive and lasting drop in asset prices: sovereign, stock and bond Amplification of flight to quality, potential for feedback amplifying downturns Safe asset price rises markets impacted Volatility Use of asset managers, benchmarks and mechanical allocation rules Liquidity pressures Common behaviour driven by common assets and liabilities Policyholder Balance sheet impacts of price falls can materially jeopardise solvency Collateral and capital ratios Intragroup Liquidity and asset pressure correlated Pro-cyclicality Changes of prices and quantities of insurance provision Correlation between risks being underwritten and financial Amplification of financial and business cycles insurance provision and business cycle Level of competition in insurance segment Double hit Material drop in asset prices and prolonged low interest Asset allocation in risky investments Delay or insufficient payout of claims rates Sensitivity to low interest rates Losses imposed on households Pace of failure/distress faster with liquidity pressure

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