Issue Analysis A Public Policy Paper of the National Association of Mutual Insurance Companies September 2009 The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation By Scott E. Harrington, Ph.D. Executive Summary he bursting of the housing bubble and resulting financial crisis have been followed by the Tworst economic slowdown since the early 1980s if not the Great Depression. This Issue Analysis considers the role of AIG and the insurance sector in the financial crisis, the extent to which insurance involves systemic risk, and the implications for insurance regulation. It provides an overview of the causes of the financial crisis and the events and policies that contributed to the AIG intervention. It considers sources of systemic risk, whether insurance in general poses systemic risk, whether a systemic risk regulator is desirable for insurers or other non-bank financial institutions, and the implications of the crisis for optional federal char- tering of insurers and for insurance regulation in general. Causes of the Financial Crisis Factors that contributed to the crisis include: • Federal government policies encouraged rapid expansion of lending to low-income home buyers with low initial interest rates, low down payments, and lax lending criteria. • Government-sponsored and private residential mortgage-backed securities, rapid growth in credit default swaps (CDS), and related instruments spread exposure to house price declines and mortgage defaults widely across domestic and global financial institutions in a complex and opaque set of transactions. • Bank holding companies aggressively expanded mortgage lending and investment, often through off-balance sheet entities that evaded bank capital requirements. Leading invest- ment banks invested aggressively in mortgage-related instruments. • Lehman Brothers, AIG, and other organizations became major writers of credit default swaps. When coupled with high leverage, CDS protection sellers became highly vulner- able to mortgage defaults. • Much residential mortgage lending shifted to an “originate and distribute” model, where originators retained little risk on the mortgages. Subprime mortgage originators were often new entrants with little reputational capital at risk. Scott E. Harrington is the Alan B. Miller Professor of Health Care Management and Insurance and Risk Management, Wharton School, University of Pennsylvania. The author wishes to thank NAMIC for financial support and Robert Detlefsen of NAMIC for his careful and objective comments. • The Federal Reserve kept interest rates of fundamental failures in U.S. and at historically low levels, which fueled foreign banking regulation. housing demand and encouraged lenders to relax mortgage-lending Systemic Risk and the Crisis criteria. • Systemic risk refers to the risk of wide- The Paradox of AIG spread harm to financial institutions and associated spillovers on the real • Apart from AIG, the insurance sector economy that may arise from inter- as a whole was largely on the periphery dependencies among those institu- of the crisis. The AIG crisis was heavily tions and associated risk of contagion. influenced by its CDS portfolio, sold Systemic risk is conceptually distinct by a non-insurance entity, AIG Finan- from the risk of common shocks to the cial Products (AIGFP), which was not economy, such as widespread reduc- subject to insurance regulation. tions in housing prices, which have the potential to harm large numbers of • Rating downgrades and declines in people and firms directly (i.e., without values of securities on which AIGFP contagion). had written credit default swaps The AIG crisis caused it to have to post large amounts • Possible sources of systemic risk was heavily of collateral. AIG also ran into major include: (1) a shock may cause one influenced by its problems with the securities lending or more financial institutions to sell CDS portfolio, sold program of its life insurance subsid- large amounts of assets at temporarily by a non-insurance iaries when borrowers requested the depressed prices, further depressing return of large amounts of collateral. prices and market values of insti- entity, AIG AIG’s overall investment portfolio tutions that hold similar assets; (2) Financial Products was significantly exposed to loss from shocks to some firms may make them (AIGFP), which reductions in values of mortgage- unable to honor their commitments, was not subject related securities. causing some of their counterparties to insurance to likewise default, with repercussions • Much of the federal government’s that cascade through financial markets; regulation. financial assistance to AIG was (3) revelation of financial problems at provided for the benefit of AIG’s CDS some institutions may create uncer- and securities lending counterpar- tainty about the effects on counter- ties, primarily domestic and foreign parties and whether other institutions banking and investment banking orga- face similar problems, so that parties nizations. It is not clear that any of become reluctant to trade until further AIG’s insurance subsidiaries would information becomes available; and (4) have become insolvent if the Federal possibly irrational contagion, where Reserve had not intervened. investors and/or customers with- draw funds without regard to whether • AIG was subject to consolidated regu- specific institutions are at risk. lation and oversight by the federal Office of Thrift Supervision and was • Prior research, which largely predates recognized as such for meeting the the growth of credit default swaps 2005 E.U. regulatory criterion for and complex securitizations, provides group supervision of financial service almost no evidence of irrational conta- entities. If the financial crisis and gion and little evidence of contagion AIG intervention are to be blamed related to counterparty risk, asset on ineffective regulation, the blame prices, or uncertainty/opacity. should reflect the substantial evidence 2 • The AIG crisis and general finan- appropriately been narrower in scope cial crisis were precipitated by the than in banking, and market discipline bursting of the housing price bubble is generally strong. Capital requirements and attendant increases in actual and have been much less binding – insurers expected mortgage defaults, which commonly have held much more capital greatly reduced the values of mort- than required by regulation. gage-related securities as new infor- mation was reflected in prices. While Proposed Regulation of there apparently were some elements “Systemically Significant” Insurers of contagion, the principal problem was the decline in security values. • A June 2009 U.S. Treasury white paper proposes regulation by the Federal • Whether AIG’s CDS portfolio and Reserve of insurance and other non- securities lending presented signifi- bank institutions it would designate as cant risk of contagion has and will systemically significant. A bill intro- be debated. Little is known about the duced by Representatives Melissa Bean extent to which an AIG bankruptcy (D-Ill.) and Edward Royce (R-Calif.) would have had significant adverse would create an optional federal char- effects beyond its counterparties, or tering system for insurers under which Systemic risk is even the extent to which its counter- the President would designate an agency low in insurance parties had hedged their bets with as systemic risk regulator for systemi- markets compared AIG or otherwise reduced their risk. cally significant state and federally char- tered insurers. The agency could force with banking, Systemic Risk in Insurance an insurer to be federally chartered. especially for property/casualty • Systemic risk is low in insurance • Strong arguments against creating a insurance, in part markets compared with banking, systemic risk regulator that could desig- because insurers especially for property/casualty insur- nate insurers and other non-bank finan- ance, in part because insurers hold cial institutions as being subject to hold greater greater amounts of capital in rela- comprehensive regulation and oversight amounts of capital tion to their liabilities, reducing their by the Federal Reserve or other agency in relation to their vulnerability to shocks. Moreover, include: liabilities. shocks to insurers do not threaten the economy’s payment system, as might – Any institution designated “systemi- be true for shocks to commercial cally significant” would be regarded banks. as too big to fail, reducing market discipline and aggravating moral • Banking crises have the potential to hazard. produce rapid and widespread harm to economic activity and employ- – Implicit or explicit government guar- ment, which provides some ratio- antees of the obligations of any insti- nale for relatively broad government tution designated systemically signifi- guarantees of bank deposits and strict cant would provide it with a material capital requirements. Because insur- competitive advantage and lower its ance, especially property/casualty, cost of capital compared with compa- poses much less systemic risk, there is nies not so designated. less need for broad government guar- antees to prevent potentially wide- – Political pressure, the history of bank spread runs that would destabilize the capital regulation, and incentives for economy. Insurance guarantees have regulatory arbitrage make it doubtful 3 that stronger capital requirements authority before and during the crisis? would offset the increased moral The answer