Global insurance regulation and systemic risk

Axel P. LehmannGroup Chief Risk Officer

Madrid, June 7, 2010

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Evolution of the systemic risk debate

Systemic risk originally constrained to banking sector as a result of asset-liability and duration mismatch and highly correlated assets (prone to same shocks) causing banks to fail in clusters

– Traditional bank run: depositors demand their money back

– Modern bank run: counterparties refuse to renew overnight loans

Regulatory reaction to old-type systemic risk– Deposit insurance to protect small depositors

– Central bank acting as lender of last resort

Financial crises of the 1990s (Mexico 1995, Asia 1997, LTCM 1998) marked turning point away from banks as sole causes of systemic risk

– Concept of contagion implies that failure of any financial institution (banks, broker dealers, hedge funds, and possibly insurers) and systematic shocks such as currency crises could quickly propagate to other institutions, markets or the whole financial system

Regulatory reaction to new-type of systemic risk– Strengthened capital and liquidity provisions

– Macro-prudential supervision of a wider range of financial market players

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Insurance and systemic risk − main findings in the Geneva Association Report

The insurance business model has specific features that make it a source of stability in the financial system

Insurance is funded by upfront premiums, providing strong operating cash-flow without requiring wholesale short-term funding

Insurance policies are generally long-term, with predictable outflows.

Liquidity risk is negligible in the insurance industry

The main risk for insurers is underwriting risk, which is idiosyncratic and can not be amplified by interactions of industry participants

During the crisis, insurers maintained relatively steady capacity, business volumes and prices

Insurers were net buyers of financial assets throughout the crisis and hence exerted a stabilizing effect on the financial system

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In conclusion − insurance is not systemically relevant

Industry recommendations*

Implement comprehensive, integrated & principle-based supervision for groupsStrengthen liquidity risk managementEstablish macro-prudential monitoring with appropriate insurance representationStrengthen risk management practicesEnhance regulation of financial guarantee insurance

Key takeaways• Implement comprehensive, integrated & principle-based supervision for

groups• The financial crisis was not precipitated by core insurance activities• Banking and insurance models are fundamentally different and so are

systemic risk implications• Focus should be on core risk activities and their associated risk profile• Failure of an insurance firm unlikely to impair the economy

* Source: Geneva Association Report, 20105

Thank you!