THE INSURANCE SECTOR TRENDS AND SYSTEMIC RISK IMPLICATIONS Based on - PowerPoint PPT Presentation

THE INSURANCE SECTOR TRENDS AND SYSTEMIC RISK IMPLICATIONS Based on Global Financial Stability Report, IMF, April 2016 Nico Valckx Workshop on Systemic Risk in Insurance Columbia Business School, October 28, 2016

Motivation and Main Findings

Motivation (1)  Insurance sector:  Big player in financial markets  Important economic functions Relative Size of Financial Intermediaries (Percent of GDP) 450 400 Insurance Banks OFIs Pension funds 350 300 250 200 150 100 50 0 2005 2015 2005 2015 2005 2015 2005 2015 2005 2015 2005 2015 United States Canada Euro area United Kingdom Japan Korea

Motivation (2) • Two views on systemic risk Domino View Tsunami View System of Individual insurers insurers … Distress? … … Shock to asset prices Large complex interconnected Common exposures Counter- party Default, Correlated stress … stop sales, fire risks to funding, sales, real stop stop/reduce activity lending, funding. securities.

Questions answered in GFSR Implications for insurance regulation? What explains changes in systemic importance? • Investment behavior Has insurance • Maturity sector’s systemic mismatches importance • Business models changed over • Broader market dynamics time/countries?

Main findings • Increased, esp. life, but lower than banks Systemic • More homogenous, higher commonalities importance • Increased market risk and interest rate sensitivities • Insurers transmit shocks across financial system Spillovers • Especially in Europe and North America • No major shift towards “riskier” assets Life insurers’ • But assets have become “riskier” assets • Search for yield among weaker, smaller firms • Macro-prudential approach needed Regulatory • International capital and transparency standards implications • Focus on smaller and weaker firms

Insurance Sector: Systemic Importance

Increased price comovement among insurers Time series clustering Insurers’ Equity Return Due to First Principal Component (Percent) (Number of clusters) 100 80 60 40 20 0 I II I II I II I II I II Life Nonlife Life Nonlife Mixed United States Europe

Systemic Risk – rising CoVaR and capital shortfalls North America Europe Advanced Asia CoVaR Indices (Normalized, 2006=100) 350 350 350 Life Life insurers 300 300 300 Banks insurers Banks 250 250 250 200 200 200 Banks Nonlife 150 Life 150 150 insurers insurers Nonlife 100 100 100 insurers Nonlife 50 50 50 insurers 0 0 0 2006 2009 2012 2015 2006 2009 2012 2015 2006 2009 2012 2015 Conditional capital shortfall (USD trillions) 1.2 2.0 0.8 Life insurers Life insurers Life insurers Nonlife insurers Nonlife insurers Nonlife insurers 1.5 0.6 Banks 0.8 Banks Banks 1.0 0.4 0.4 0.5 0.2 0.0 0.0 0.0 2001 2004 2007 2010 2013 2016 2001 2004 2007 2010 2013 2016 2001 2004 2007 2010 2013 2016

Systemic Risk Default Correlation Networks rank Life high Forward-Looking Default Correlation Networks (Percent; over- or underrepresentation of insurers) Life insurers Non-life insurers 20 Top 25 Top 50 Top 100 8 Top 25 Top 50 Top 100 18 4 16 14 0 12 10 -4 8 6 -8 4 -12 2 0 -16 Nov-01 Mar-07 Aug-08 Dec-14 Nov-01 Mar-07 Aug-08 Dec-14 A +10 percent value for the top 100 indicates that there are 10 percent more insurance firms among the top 100 than justified by their sample share.

Systemic Risk Spillovers: Insurance is shock transmitter

Systemic Importance Drivers

Investment behavior • Take on greater asset risk in low interest rate environment? Across asset categories true only for weaker, smaller firms • Increased similarity in asset composition? Not apparent • Greater procyclicality in investment behavior? Mixed evidence • But greater common exposure to aggregate risk interest rates

1. More risky investments: at lower cap, smaller firms and those with more annuity/min.return products In low interest environments, factors 1 2 … a higher share of annuity products that contribute to higher exposure to in total liabilities … riskier assets are lower-capitalization …. 6 15 Firms with higher With low interest rates, the With low interest rates, the guaranteed interest propensity of firms with higher propensity of lower-capitalized 4 rates on life annuity product shares to hold firms to hold riskier assets is 10 insurance offerings riskier assets is strengthened. strengthened. have larger risky 2 asset portfolios. 5 0 0 -2 -5 -4 High Low High Low High Low Guaranteed High Low High Low High Low All interest interest interest interest interest interest interest interest interest interest interest interest interest United States Canada Netherlands Germany United States Canada Netherlands Germany 15 … and the size of the firm , 3 10 with smaller being more 5 exposed 0 -5 With low interest rates, the propensity of smaller firms to hold -10 riskier assets is strengthened. -15 High Low High Low All All All interest interest interest interest United States Canada Netherlands Germany Korea

2. Procyclicality 3. Duration mismatches - Mixed evidence - Higher i-rate sensitivity U.S. insurers acted countercyclically in 2008 US and European Insurers' Equity Returns‘ and contributed to stability Interest Rate Sensitivity Increases …and so does their net duration mismatch 0.10 Precrisis Postcrisis 0.00 -0.10 -0.20 -0.30 -0.40 -0.50 -0.60 -0.70 -0.80 Life Nonlife Life Nonlife Mixed Life Nonlife U.S. insurers European insurers Asian insurers But… turnover at firm level did not increase Note: For a negative (net) duration, insurers’ liabilities are in recent years longer than their assets. Insurers’ future business prospects get better (worse) when interest rates increase (fall).

4. Liability side developments may also contribute to riskiness… Life Insurers’ Unit-Linked Products Alternative Insurance Risk Capital (Percent of assets) Instruments United States Netherlands (Percent) (Billions of U.S. dollars) Germany United Kingdom 80 70 Catastrophe bonds 20 Sidecars Korea Scandinavian countries 70 60 Industry loss warranties Switzerland Canada Collateralized re and other 60 15 50 Share alternative capital (right scale) 50 40 40 10 30 30 20 5 20 10 10 0 0 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015:H1 2004 2006 2008 2010 2012 2014 Unit-linked products are a form of long-term insurance whereby the policyholder chooses the investment strategy. These products can, but do not necessarily have to, include guarantees.

5. Changed Market Dynamics Higher cross-asset correlations post-2010 Greater similarity • Search for yield Temporary across • Lower risk aversion factors insurance firms’ stock prices Insurance Increase risk of market stocks more illiquidity Structural affected by Benchmarking more changes common widespread shocks

Implications for Regulation

Recent Regulatory Developments • Regulations now more risk-based and accounting principles more market-based – valuations more market-sensitive – investment horizons of risky investments shortened – the maturity of safe assets extended • Wide variations in capital requirements and the use of internal models – These are among the main problems in developing a global capital framework – But progress is being made

Compliance with ICPs 1. Selected IAIS Core Principles on Regulation 2. Selected IAIS Core Principles on Business Strategies Observed Unobserved Observed Unobserved 100 100 80 80 60 60 40 40 20 20 0 0 AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM AE EM Exit M&A Cond. Enforce. PCA Report MaPru. Groups Activity Invest. Liab. Risk Mgt. Cap. Gov. Disclose

Forward looking lessons for Regulation • Macro-prudential approach – address risks related to common exposures • Market-consistent valuation standards – enhance transparency – address duration mismatches • Supervisory follow-up of smaller and weaker firms – Focus should not be restricted to only large firms – Too-many-to-fail problem – Contagion • Vigilance to avoid regulatory arbitrage