Do Insurance Companies Pose Systemic Risk?

1. Do Insurance Companies Pose Systemic Risk? J. David Cummins, Temple University NAIC Winter 2009 National Meeting Perspectives on Systemic Risk December 3, 2009 Copyright J. David Cummins, 2009, all rights reserved. Not to be reproduced without author’s permission.

2. Outline of Presentation • What is Systemic Risk? • Too Big To Fail – Not just for financial institutions • Insurers: How Big Are They? • Relative to banks • Fraction of GDP • Insurers: How Solvent Are They? • Insolvency rates • Guaranty fund assessments • Stock performance • Do flat guaranty fund premia create moral hazard? • AIG: What Went Wrong? • Does insurance pose a systemic risk? • If so, what are the systemic threats to the industry?

3. What is Systemic Risk?

4. What Is Systemic Risk? • The risk that an event will trigger a loss of economic value or confidence in a substantial segment of the financial system serious enough to have significant adverse effects on the real economy. Group of 10 (2001). • Systemic financial risk involves • A system-wide financial crisis . . . accompanied by a sharp decline in asset values and economic activity • The spread of instability throughout the financial system (contagion) • Sufficient to affect the real economyWorld Economic Forum (2008). • Systemic risk is exposure to extreme correlations

5. Financial Crisis and Systemic Risk • Financial Crisis • Prices of risky assets drop sharply • Prices of safe assets increase (flight to quality) • Asset price volatility increases • Liquidity dries up (rising bid-ask spread & price impact) • Financial institutions become financially distressed • Credit markets dry up, economic activity depressed • Financial systemic risk: Financial crisis in which many institutions become financially distressed, with a potential impact on real economic activity Financial distress does not mean systemic risk!

6. All Systemic Financial Crises Involve “Runs” • In crisis, investors seek cash at all costs • As prices no longer adjust supply, access to credit becomes central • Maturity mismatch compounds shock and spreads runs • Rapid withdrawals lead to “fire sales,” prices crash • Losses induce margin calls, more fire sales • Runs are both cause and consequence of extreme correlation • Crises that do not spread to general credit market do not qualify (e.g., “dot-com” bubble)

7. “Too Big to Fail” & “Too Interconnected to Fail” • Institutions that pose significant systemic risk are viewed as “Too Big to Fail” -- e.g., failure would cause ripple effects throughout the economy due to the sheer size of the enterprises • “Too Interconnected to Fail” -- Firms with multiple counterparty relationships could trigger a cascading chain of failures – “domino effect”

8. Too-Big-To-Fail Has Been With Us For a Long Time and Isn’t Confined to Financial Institutions

9. Insurers:How Big And How Risky?

10. Total Assets: US Banks and Insurers Assets: Banks $14 trillion, insurers $5.8 trillion. Source: Federal Reserve Flow of Funds accounts.

11. Total US Life and P-C Premiums: % of GDP Source: A.M. Best Company, American Council of Life Insurance, St. Louis Federal Reserve Bank.

12. Insurance Companies: Share of Total Assets Source: Federal Reserve Flow of Funds Accounts.

13. Equity Capital-to-Assets Ratios Source: Federal Reserve Flow of Funds accounts, American Council of Life Insurance.

14. Premiums-to-Surplus Ratios: US Insurers

15. P/C Insurer Impairments: 1969-2008 Historically low impairments in 2007-2008. Source: A.M. Best; Insurance Information Institute

16. P/C Insurer Impairments & Combined Ratio Impairment rates are highly correlated with underwriting performance but reached record lows in 2007/2008 Source: A.M. Best; Insurance Information Institute

17. P/C Impairment: Triggering Events Deficient loss reserves, inadequate pricing, and rapid growth are the leading triggers. Investment & catastrophe losses play a much smaller role. Source: A.M. Best: 1969-2008 Impairment Review, Special Report,Apr. 6, 2009.

18. Life/Health Insurer Impairments:1976-2008 Life/health impairments less cyclical than P/C Source: A.M. Best, National Organization of Life and Health Insurance Guaranty Associations.

19. L-H Impairment Frequency & Profits L-H: Less obvious relationship with profits than P-L Source: A.M. Best.

20. L-H Impairments: Triggering Events Life insurers more susceptible to affiliate problems. Inadequate pricing, affiliate problems, rapid growth, and investments are primary causes of L/H insolvencies. Source: A.M. Best: 2009 U.S. Life/Health – 1976-2008 Impairment Review, Special Report, May 25, 2009.

21. Property-Casualty InsurerGuaranty Fund Assessments: 1978-2007 Source: A.M. Best Company, National Conference of Insurance Guaranty Funds.

22. Life-Health Insurer Guaranty Fund Assessments: 1988-2007 Source: A.M. Best, National Organization of Life and Health Insurance Guaranty Associations.

23. US Life Insurers: 12 Month Change in Premiums (as of June 30, 2009) Source: A.M. Best Company.

24. US Insurance Stock Indices vs. S&P 500 PC insurers beat the S&P, life insurers do not. Source: A.M. Best Company.

25. Insurer Solvency: Conclusions • Insurers have about $6 trillion in assets but are not especially large relative to overall economy (8% of total U.S. financial assets) • US regulated insurance companies highly solvent • Insolvency rates are low • Guaranty fund costs are low • Life insurers give cause for concern • May be over-leveraged • Recent adverse performance is danger signal • More interconnected than PC insurers (susceptibility to affiliates) • Inter-connectedness does not pose serious solvency threat for PC insurers based on past experience • Monolines are a different story – but not traditional insurance

26. Do Guaranty Funds Create Moral Hazard? • In theory, mis-priced guaranty fund coverage provides incentives for excessive risk-taking • In practice, guaranty funds do not seem to be a problem • So-far, at least, there is no solvency crisis for US regulated insurance companies • Guaranty fund assessments have been very low • Possible rationale: • Risk-based capital (introduced in 1994) blunts insurer incentives for excessive risk-taking • GF protection is incomplete (low maximums, etc.)

27. AIG: What Went Wrong?

28. AIG: What Went Wrong? • AIG’s traditional insurance operations did not cause its meltdown • AIG’s problems came from: • Credit default swaps out of AIG Financial Products • (Supposedly) regulated by Office of Thrift Supervision • US regulators had no jurisdiction • Securities lending program of life insurance subsidiaries • Indicates need for more regulatory scrutiny in the future • US regulators do have jurisdiction if lending is out of regulated life insurance subsidiaries

29. AIG Revenues Before the Crash 12 months ending 12/31/2006.

30. AIG’s Credit Default Swaps • AIG sold CDS contracts, mostly to European banks • Banks were using the swaps to reduce regulatory capital, relying on AIGs overall credit rating (regulatory arbitrage) • AIG Financial Products had about $500 billion in CDS outstanding but virtually no capital • AIG’s models supposedly showed that losses on the CDS portfolio were virtually impossible • Watch out for model risk and managerial moral hazard

31. AIG’s Securities Lending Operation • AIG loans securities to broker dealer or bank (e.g., to cover short selling or for diversification) • Borrower posts collateral in form of cash or high quality securities • AIG reinvests the collateral and earns spread between yield on invested assets and yield on underlying securities • AIG had $82 billion in liabilities for securities lending as of year-end 2007, $69 billion in August 2008

32. AIG Securities Lending: What Went Wrong • Declines in value of mortgages and other assets in 2007-2008 reduced value of reinvested collateral in securities lending programs • Many of the counterparties in the securities lending operation were the same institutions holding AIG credit default swaps • As asset values declined, borrowers terminated the securities lending arrangement to • Improve liquidity • Reduce exposure to AIG’s credit risk • At the same time, AIG had to post additional collateral for the CDS transactions as underlying “insured” asset values declined

33. The Bailout: Payments to AIG Counterparties

34. US Insurer Assessments vs. AIG • Total US life and P-C assessments: 1988-2007 $18 billion • Federal assistance to AIG (as of June 30, 2009): $136 billion • Not necessarily a net loss • But . . . . • Total assets of largest insurers: 2008 • Met Life: $422.6 billion • State Farm: $116.5 billion Source: A.M. Best Company, Harrington (2009).

35. Failure Costs: Met Life and State Farm(% of Life & PC Industry Assets, resp.) Source: A.M. Best Company, author’s calculations.

36. Does Insurance Pose Systemic Risk?

37. What Is Systemic Risk Policy Trying to Prevent? • Runs on banks – traditional concern • Contagion – information asymmetries • Banking system collapse – • Continental bank • Correspondent bank collapse – counterparties • Jobs would be lost • Threat to settlement system and network effects • Fear that Infrastructure of short term money market and OTC derivatives would not handle failure of significant counterparty and might cast doubts on the soundness of other counter parties (Bernanke on Bear Stearns) • Panic due to loss of confidence • Risks to system due to failure of “highly interconnected” firm • “Unpredictable consequences of a failure for broader financial system” • Reaction of counterparties of other firms that might come under future government control • AIG was large, complex and interconnected whose failure would impose losses on counterparties and also endanger the entire world’s financial sector (Bernanke-Morehouse University)

38. Property-Casualty Insurance Does Not Create Systemic Risk • “Runs” are not possible • To obtain funds, it is necessary to have a claim • Unlike bank deposits, which are instanteously “putable” • Inter-sector exposure among insurers and between insurers and reinsurers not sufficiently large to cause cascading failures (e.g., reinsurance failures and affiliate problems account for about 11% of P-C failures but 20% in L-H insurance) • Insurance not involved in liquidity creation, payments system or business/consumer lending • Insurers hold only small proportion of total invested assets in the economy • Insurance claim payments not a major financial asset for any economic sector

39. Does Life Insurance Pose Systemic Risk? • Why LI may be systemically risky • Life insurance investment products are susceptible to “runs” (withdrawals and/or suspension of premium payments/annuity considerations) • Life insurers are thinly capitalized • Insurance guaranty fund system probably not adequate for a major run or liquidity crisis • Life insurers owned by banks (and vice versa) could add to fragility of banking system

40. Does Life Insurance Pose Systemic Risk? • Why LI may NOT be systemically risky • Life insurance sector not involved in payments system, liquidity creation, credit creation, etc. • Life insurers own only small proportion of stocks and bonds in the economy (about 6%) • Life insurance is a small proportion of household financial assets (about 3%) • Life insurers not major employers (< 2% of non-farm civilian labor force) • Disappearance of the entire sector would be tragic but sustainable

41. Systemic Risk In Insurance: Banking Activities • As AIG debacle shows, the main systemic risk posed by the insurance industry comes from insurer participation in “banking” activities, e.g., credit default swaps (CDS) and other derivatives • Swiss Re data shows that insurers and reinsurers accounted for 33% of CDS market in early 2000s • As with AIG, most insurers are not adequately capitalized to sustain large CDS meltdown • Insurance groups should not be permitted to conduct CDS operations

42. Systemic Risk and OTC Derivatives • “Too big to fail” partly based on counterparty risk • Reduce counterparty risk by moving popular products to centralized clearing – e.g., credit default swaps • Reduce remaining counterparty risk by trade transparency • Liquidity also improved by enhanced transparency • Require CDS writers to hold adequate capital • Derivatives trading poses significant “model risk,” i.e., impossible to foresee all possible eventualities that could cause major losses.

43. Systemic Threats to Insurance Industry • Future AIG-style episodes – conducting high risk derivatives operations out of non-insurance subsidiaries • Reveal need for better regulation and regulatory coordination • Toxic asset problems – investing in risky or inaccurately rated structured securities • Not clear that regulators have enough information on insurer investments in such assets • Major catastrophes causing melt-down of Florida’s hurricane insurance system – public bond defaults and pressures for Federal bailout • Minimum rate guarantees and excessive risk taking for annuities, especially variable annuities

44. Systemic Risk: Lessons • At the national level, the financial crisis exposed the limits of supervision that is geared only to local entities and neglects the systemic implications of financial institutions with global reach • There can be little doubt that global governance and the institutions charged to develop the frameworks and carry out such governance should be strengthened (World Economic Forum 2009)

45. Further Information • American International Group, 2009, AIG: Is the Risk Systemic? Powerpoint presentation (New York). • De Bandt, Olivier and Philipp Hartmann, 2000, Systemic Risk: A Survey (Frankfurt, Germany: European Central Bank). • Group of 10, 2001, Report on Consolidation in the Financial Sector • Harrington, Scott E., 2009, The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation (Indianapolis, IN: National Association of Mutual Insurance Companies). • Kaufman, George G., 1996, “Bank Failures, Systemic Risk, and Bank Regulation,” The CATO Journal 16: 17-45. • Kaufman, George G., 2000, “Banking and Currency Crises and Systemic Risk: Lessons from Recent Events,” Federal Reserve Bank of Chicago Economic Perspectives 24: 9-28. • Swiss Re, 2003, Reinsurance – A Systemic Risk, Sigma No. 5/2003 (Zurich, Switzerland). • World Economic Forum, 2009, Global Risks 2009 (Geneva, Switzerland).