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INSURANCE, SYSTEMIC RISK

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INSURANCE, SYSTEMIC RISK & THE FINANCIAL CRISIS Faisal Baluch, Chris Parsons & Stanley Mutenga Cass Business School, City of London * SYSTEMIC RISK A financial ... – PowerPoint PPT presentation

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Title: INSURANCE, SYSTEMIC RISK


1
INSURANCE, SYSTEMIC RISK THE FINANCIAL
CRISIS Faisal Baluch, Chris Parsons Stanley
Mutenga Cass Business School, City of London
1
2
AIMS OF THE PAPER
? A broad assessment of the impact of the
Financial Crisis on the insurance sector ?
Evaluation of systemic risk in insurance
2
3
GENEVA ASSOCIATION RESEARCH
Systemic risk in insurance an analysis of
insurance and financial stability (March
2010) Key findings ? No systemic risk from
insurers core activities ? Insurance business
model a source of stability, not the reverse
3
4
TOPICS
1 Historic insurance crises 2 Effect of
the Crisis on insurance risk 3 Effect of the
Crisis on insurers performance 4 Systemic risk
in insurance
4
5
HISTORIC INSURANCE CRISES
? Crisis implies the failure of many
insurance firms and/or failure in the supply of
insurance, leading to economic disruption ?
Examples ? 1984-6 US liability insurance
crisis ? 1976-7 product liability crisis
? lack of terrorism cover post 9/11 ?
Lloyds near-collapse 1988-92
5
6
INSURANCE CRISES
? Typically short, local and limited in their
effects ? Never a world-wide insurance
crunch
6
7
LESSONS FROM HISTORY 1 - LOYDS CRISIS 1988-92
? Massive losses mainly on US liability
business (asbestos, pollution, med-mal) ?
Names (investors) pulled out so capital
disappeared ? Lloyds mired in litigation ?
The LMX reinsurance spiral (syndicates ABC
reinsure with CDE, which reinsure with FGH, which
reinsure with IJK, which reinsure with ABC, which
reinsure with CDE etc etc)
7
8
LESSONS FROM HISTORY 1 - LOYDS TODAY
? Lloyds came through the Crisis almost
unscathed ? Has focused on core insurance
business and risks it understands ? Very
little exposure to equity markets
8
9
EFFECT OF THE CRISIS ON INSURANCE RISK
? Recession has dampened demand for some
lines of insurance ? Life insurers most
affected in Western markets ? Non-life
insurers seeing higher levels of insurance
fraud ? Some lines of insurance are
especially sensitive to a financial
crisis/recession e.g. liability insurance and
insurance involving credit risk
9
10
LIABILITY INSURANCE
? Lines most affected are Errors and Omissions
(EO) and Directors and Officers insurance
(DO) ? Estimated losses US9.6bn, (5.9bn
for DO, 3.7bn for EO (Advisen, 2008) ?
This is long tail business, so final cost will
not be known for many years ? AIG is the
market leader writes 35 of DO
10
11
UNDERWRITING OF CREDIT RISK BY INSURERS
? Various lines of insurance cover some credit
risk, e.g. Payment Protection Insurance (PPI)
and Mortgage Protection Insurance (MPI) ?
Most important is credit insurance - covers
losses made by firms whose customers fail to
pay for goods or services provided (usually
owing to insolvency) ? Market leaders (e.g.
Euler Hermes) have taken big losses and supply
has diminished this has affected trade and
deepened the recession to some extent
11
12
LESSONS FROM HISTORY 2 CUTHBERT HEATHS EIGHT
COMMANDMENTS ON CREDIT INSURANCE
1. Credit insurance should be concerned with
credit risks for goods sold and delivered by
merchants and manufacturers to their customers
on credit terms in the normal course of
business. 8. Financial credits such as
loans by banks or finance houses should not be
insured.
12
13
                                                        Cuthbert Eden Heath OBE 1859-1939  Insurance businessman Founder of CE Heath Ltd IIS Hall of Fame Induction Year 1966      
14
WHICH WERE THE BIG INSURANCE LOSERS?
? Specialist financial guarantee insurers (e.g.
US monolines) ? Companies which dabbled in
risky areas of structured finance (e.g. AIG and
Swiss Re) ? Firms writing business which is
sensitive to an economic downturn (e.g. credit
and liability insurers) ? Bancassurers
integrated financial services providers and
insurers having close affiliations with
banks ? Insurance firms holding a high
proportion of risky assets (some US life
insurers especially)
14
15
EFFECT ON INSURANCE MARKET STRUCTURE
? Some insurers needing to raise fresh
capital ? Smaller/weaker firms vulnerable to
MA activity ? Insurers will re-focus on core
business strengths to conserve capital and
reduce risk ? Bancassurance models are called
into question few benefits for insurers in the
current climate?
15
16
REGULATION
? Stronger regulation of banking sector
inevitable will it spill over to insurance
sector? ? Current capital adequacy regimes
(e.g. EU Solvency II project) believed to be
sufficient ? Regulators may seek to re-impose
laws which separate banking, securities/investmen
t and insurance ? Tighter regulation of some
(non-regulated) financial products e.g. Credit
Default Swaps ? Need for harmonisation of
guarantee funds in insurance, banking and
securities
16
17
BRITISH BANKERS APOLOGISE FOR THE FINANCIAL
CRISIS . (A LITTLE)
                                               
            Read more http//
18
(No Transcript)
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SYSTEMIC RISK IN INSURANCE
? Money cannot be withdrawn from an insurer on
demand so no run on the insurer ?
Insurers liabilities arise mainly from
localised and non- correlated perils (fires,
crashes, storms, negligence suits) these can
be diversified quite easily across the globe
? Insurers do not trade with each other
extensively though reinsurance is an exception
21
22
SYSTEMIC RISK
  • A financial phenomenon that causes widespread
    downturn in economic regions and industry
    sectors. It is derived in two ways
  • 1 Micro Systemic Risk
  • Financial contagion as a result of multitude of
    events leading to a chain reaction
    (Spill-over/Domino effect).
  • 2 Macro Systemic Risk
  • Financial contagion as a result of simultaneous
    impact by a single event (i.e. downturn in the US
    residential market).

23
SYSTEMIC RISK IN THE INSURANCE AND BANKING
SECTORS
Traditional levels of systemic risk Banking
Sector Strong form Insurance Sector Weak
form
Current levels of systemic risk Banking Sector
Strong form Insurance Sector Semi-strong form
23
24
WHAT HAS CHANGED?
  • Expansion of bancassurance
  • Insurers big players in the derivative market
    (namely CDS)
  • Insurers and banks connected via funding channel
    (Capital Market)

25
CREDIT DEFAULT SWAPS (CDS)
? Global market volume for CDS just USD 1.189
Trillion in 2001. Sellers included US
monoline (financial guarantee) insurers and
reinsurers (market share 20) and primary
insurers (13 share) 33 in total ?
Insurers share now down to about 17 - but
market for CDS has grown to around US60
Trillion ? Big insurance losers on CDS
include US monolines (e.g. AMBAC, MBIA, CIFG
Guaranty), Swiss Re, AIG ? AIGs mainstream
insurance business relatively sound ? CDS not
insurance for regulatory purposes much of the
market for CDS has been unregulated posing CDA
risk
25
26
REINSURANCE AS A FORM OF SYSTEMIC RISK
  • The sector faces the following risks via
    Reinsurance
  • Credit Risk - Possibility of default by
    Reinsurer
  • Systemic Risk - Caused by the linkage between
    Reinsurance market and the capital markets
    (potential for micro-systemic risk)
  • What is the likelihood of Systemic Risk via the
    Reinsurance sector?
  • No historical large scale default of any
    Reinsurer
  • Insurers diversify pure risk to various
    Reinsurers thus reducing concentrated credit risk
    exposure
  • Retrocession helps diversify risk further

27
REASONS FOR INSURANCE COMPANY FAILURE (US
PROPERTY/CASUALTY) 1969 - 2005
Source A.M. Best
28
HOWEVER .
Reinsurers are active participants in the capital
markets Their involvement in the derivative
market strengthens the micro systemic link with
the banking sector and thus could pose contagion
through to the insurance sector
29
CHANGES TO COME AS A RESULT OF THE RECENT
SYSTEMIC CRISIS
  • Bancassurance model change - Spin-offs between
    banking and insurance divisions
  • Regulatory changes to tighten controls on insurer
    capital holding requirements
  • Insurers to curb involvement in the derivatives
    market

30
CHANGES TO COME AS A RESULT OF THE RECENT
SYSTEMIC CRISIS
Even with such changes, the insurance sector
remains exposed to Systemic Risk. Developments
over the last decade have lead to a move away
from the traditional insurance business model and
greater linkages with other financial sectors.
This seems likely to continue, given the
increasing array and magnitude of risks that
require diversification
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