Is a capital surcharge the right instrument to control systemic risk in insurance?

1 FINANCIAL SBILITY AT ION NEWSLETTER INSURANCE AND FINANCE Is a capital surcharge the right instrument to control systemic risk in insurance?1 by Christian Thimann2 That insurance companies are different from banks is well known. But it is less known why these differences should apply to the regulation of insurance companies when it comes to controlling possible systemic risk. Do large insurance companies differ significantly from large banks or can one essentially base their systemic regulation on one framework devised for systemically important banks? Would capital surcharges for insurance function in the same way as for banking in controlling systemic risk? And what about leverage, is that the same in insurance as in banking? Closer inspection of the balance sheet structure and the functioning of insurance compared with banking shows that there are more differences than similarities between insurance and banking. And it also shows that three crucial concepts for controlling systemic risk—capital, leverage and loss absorption capacity—are very different in insurance. Banks and insurance in systemic interaction compared Specifically, there are four main differences and two similarities between insurance and banking with regard to systemic interaction. Institutional interconnectedness: the first key difference between banks and insurers with regard to systemic risk is that banks operate within a system, namely the banking system, while insurers do not. Banks are institutionally interconnected through unsecured and secured interbank lending. The fact that there is a central bank demonstrates further that banks function, and can only function, within a system. Insurers are not institutionally interconnected; they are stand-alone operators in institutional terms. There exists no ‘insurance system’ and no ‘central insurer’ comparable to a central bank. It is sometimes argued that insurers and reinsurers together constitute a system that resembles the banking system. But such a parallel overlooks the functions and size of reinsurers, which only take up portions of the primary risks of insurers. Hence, as there exists no ‘insurance system’, the notion of systemic risk also needs to be thought of differently for insurers. Maturity transformation: banks engage in maturity transformation combined with leverage; they transform short-term liabilities into longer-term assets. Insurers do not engage in maturity transformation. They pursue a liability-driven investment approach, trying to match their asset profiles with their liability profiles. Since they are funded long-term, insurers are essentially ‘deep-pocket’ investors. This makes them react very differently to downward market pressure compared with a short-term funded or leveraged investor. Liquidity risk: liquidity risk is inherent in banking, but not in insurance. Banks risk being liquidity-short, because deposits are the largest item on banks’ balance sheets and these deposits are predominantly short-term, withdrawable at will and held exclusively by trust. Insurance liabilities are less fugitive and insurers are actually liquidity-rich. The liabilities for insurance of general protection, property, casualty and health are not callable at will. They relate to exogenous events that policyholders 1 For the complete paper see The Geneva Papers on Risk and Insurance—Issues and Practice 40(3): 359-384 (2015). 2 Member of the Executive Committee, AXA Group, and Affiliated Professor at the Paris School of Economics. No. 16 September 2015 @TheGenevaAssoc INSURANCE AND FINANCE