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Systemic Risk in Insurance An analysis of insurance and financial stability Special Report of The Geneva Association Systemic Risk Working Group Ma rch 201 0 The Geneva Association (The International Association for the Study of Insurance Economics) The Geneva Association is the leading international insurance “think tank” for strategically important insurance and risk management issues. The Geneva Association identifies fundamental trends and strategic issues where insurance plays a substantial role or which influence the insurance sector. Through the development of research programmes, regular publications and the organisation of international meetings, The Geneva Association serves as a catalyst for progress in the understanding of risk and insurance matters and acts as an information creator and disseminator. It is the leading voice of the largest insurance groups worldwide in the dialogue with international institutions. In parallel, it advances—in economic and cultural terms—the development and application of risk management and the understanding of uncertainty in the modern economy. The Geneva Association membership comprises a statutory maximum of 80 Chief Executive Officers (CEOs) from the world’s top (re)insurance companies. It organises international expert networks and manages discussion platforms for senior insurance executives and specialists as well as policy-makers, regulators and multilateral organisations. The Geneva Association’s annual General Assembly is the most prestigious gathering of leading insurance CEOs worldwide. Established in 1973, The Geneva Association, officially the “International Association for the Study of Insurance Economics”, is based in Geneva, Switzerland and is a non-profit organisation funded by its members. President: Dr Nikolaus von Bomhard, Chairman of the Management Board, Munich Re Group, Munich. Vice Presidents: Mr Michael Diekmann, Chairman of the Management Board, Allianz SE, Munich; Mr Kunio Ishihara, Chairman of the Board, Tokio Marine & Nichido Fire Insurance Co., Tokyo; Mr John Strangfeld, Chairman and CEO, Prudential Financial, Inc., Newark. Members of the Board: Dr Carlo Acutis, Vice President, Vittoria Assicurazioni S.p.A., Turin; Mr Antoine Bernheim, President, Assicurazioni Generali S.p.A., Trieste; Ms Christine Bosse, CEO, TrygVesta Group, Ballerup; Mr Henri de Castries, Chairman of the Management Board and CEO, AXA Group, Paris; Mr Patrick de Larragoiti Lucas, President, Sul America Seguros, Rio de Janeiro; Prof. Denis Kessler, Chairman and CEO, SCOR, Paris; Dr Stefan Lippe, CEO, Swiss Re Group, Zurich; Mr José Manuel Martinez, Chairman, MAPFRE SA, Madrid; Mr Andrew Moss, CEO, Aviva plc, London; Mr James J. Schiro, CEO, Zurich Financial Services, Zurich; Mr Donald A. Stewart, CEO, Sun Life Financial Inc., Toronto; Mr Patrick Thiele, President and CEO, Partner Re Insurance Co., Pembroke; Mr Mark Tucker, Group Chief Executive, Prudential plc, London; Dr Richard Ward, CEO, Lloyd’s, London. Secretary General and Managing Director: Mr Patrick M. Liedtke (Head of Insurance and Finance), Geneva. Vice Secretaries General: Prof. Jan Monkiewicz (Head of Progres and Liaison—Eastern Europe), Warsaw; Mr Walter Stahel (Risk Management), Geneva. Heads of Research Programmes: Dr Christophe Courbage (Health & Ageing and Insurance Economics) Geneva; Ms Geneviève Reday-Mulvey (Four Pillars) Geneva. Head of Communications: Mr Anthony Kennaway, Geneva. Special Officers: Mr Katsuo Matsushita (Liaison—Japan & East Asia), Yokohama; Dr Bruno Porro (Chairman of Chief Risk Officers Network), Zurich; Mr Gordon Stewart, (Liaison—Eastern North America), New York. Chairman of the Scientific Advisory Council: Prof. Harold Skipper, Georgia State University, Atlanta. Former Presidents of The Geneva Association: Mr Raymond Barre, Paris (1973-1976); Mr Fabio Padoa, Trieste (1976-1983); Mr Julius Neave, London (1983-1986); Prof. Dr Dr e.h. Reimer Schmidt, Aachen (19861990); Sir Brian Corby, London (1990-1993); Drs. Jan H. Holsboer, Amsterdam (1993-1999); Mr Walter Kielholz, Zurich (1999-2003); Mr Henri de Castries, Paris (2003-2008); Mr Martin J. Sullivan, New York (2008); Mr Jacques Aigrain, Zurich (2008-2009). Systemic Risk in Insurance An analysis of insurance and financial stability Special Report of The Geneva Association Systemic Risk Working Group The Geneva Association 53 Route de Malagnou, CH-1208 Geneva, Switzerland E-mail: secretariat@genevaassociation.org Tel: +41-22-707 66 00 Fax: +41-22-736 75 36 www.genevaassociation.org March 2010 © The Geneva Association Systemic Risk in Insurance—An analysis of insurance and financial stability Published by The Geneva Association (The International Association for the Study of Insurance Economics) Contents Foreword 1 Executive summary 3 0. Introduction 5 0.1. Purpose of this report 0.2. Report structure 0.3. The economic and social role of insurers 0.3.1. Providing protection for individuals and their possessions 0.3.2. Financing the economy through the premiums raised 0.4. The importance of insurance in numbers 0.5. The different types of insurers’ business models 1. Setting the scene 1.1. The financial crisis: the different effects on banks and insurers 1.1.1. Insurers vs. banks: capital and capacity 1.1.2. Insurers vs. banks: stable volume and pricing 1.2. The effects of the crisis on the insurance industry 1.2.1. Insurers with limited banking activities 1.2.2. Bank-insurance conglomerates 1.2.3. Insurers with wholesale banking operations: AIG 1.2.4. Monoliners 1.2.5. Conclusion 1.3. Why did insurers fare better? 1.4. Conclusion 2. FSB and IAIS definition of systemic risk 2.1. Size 2.2. Interconnectedness 2.3. Substitutability 2.4. Timing 2.5. Contributing factors to the assessment of systemic importance 2.6. Wind-up and run-off: insurance industry experience 2.7. Conclusion on the FSB and IAIS criteria for systemic risk 3. Assessing systemic relevance of insurers’ risk activities 3.1. Investment management activities 3.1.1. Asset liability management and strategic asset allocation 5 5 5 6 6 7 8 11 11 12 13 15 15 16 17 18 20 20 22 23 24 25 26 28 29 29 31 33 35 35 i Systemic Risk in Insurance—An analysis of insurance and financial stability 3.1.1.1. Exposures to other financial institutions 3.1.1.2. Investment in equities 3.1.1.3. Investment in callable bonds 3.1.1.4. Programme trading 3.1.2. Derivatives activities on non-insurance balance sheets 3.2. Liability origination activities 3.2.1. Underwriting catastrophic risks 3.2.2. Underwriting long-term risks 3.2.3. Writing business with redemption options 3.2.4. Writing life insurance with embedded guarantees 3.3. Risk transfer activities 3.3.1. Hedging with derivatives 3.3.2. Reinsurance and retrocession 3.3.3. Insurance linked securities and insurance derivatives 3.4. Capital, funding and liquidity management activities 3.4.1. Mis-management of short-term funding raised through commercial paper or securities lending 3.4.2. Raising debt or equity capital 3.5. Credit protection activities 3.5.1. Credit insurance 3.5.2. Financial guarantees 3.5.3. CDS writing 3.6. Conclusion 4. The Impact of regulatory regimes on identified systemic risk issues 4.1. Introduction 4.2. Assessment of systemically relevant risk activities under the European and U.S. regulatory regimes 4.2.1. Derivatives activity on non-insurance balance sheets 4.2.1.1. Assessment of European insurance regulation 4.2.1.2. Assessment of U.S. insurance regulation 4.2.2. Mis-management of short-term funding raised through commercial papers or securities lending 4.2.2.1. Assessment of European insurance regulation 4.2.2.2. Assessment of U.S. insurance regulation 4.3. International regulatory initiatives 5. Mitigating measures 5.1. Principles of selecting a mitigating measure 5.2. Mitigating measures targeted to specific identified issues 5.2.1. Measure 1: Implement comprehensive, integrated and principle-based supervision of insurance groups 5.2.2. Measure 2: Strengthen liquidity risk management 5.3. Additional measures promoting financial stability 5.3.1. Measure 3: Enhance regulation of financial guarantee insurance 5.3.2. Measure 4: Establish macro-prudential monitoring with adequate insurance representation 5.3.3. Measure 5: Strengthen risk management practices ii 36 37 38 39 40 40 41 44 46 48 49 49 50 53 55 55 58 58 58 59 61 63 65 65 66 66 66 67 67 67 68 68 71 71 72 72 73 74 74 74 75 Appendix A. Timeline of the crisis 77 Appendix B. Case studies of troubled insurers 87 B.1. AIG B.2. ING B.3. The Hartford Appendix C. Size and diversification of insurers C.1. Size of top 10 European insurers and banks C.2. Size of top 10 North American insurers and banks C.3. Diversification of European insurers 87 90 91 93 93 94 95 Appendix D. Insurer wind-ups: Equitable Life and HIH D.1. Case study: the failure of Equitable Life Assurance Society in the U.K. D.2. Case study: the failure of HIH Insurance in Australia Appendix E. EU insurance regulation: Solvency II 97 97 99 103 Appendix F. U.S. insurance regulation with focus on RBC 105 Appendix G. Swiss insurance regulation: the Swiss Solvency Test (SST) 107 Appendix H. Solvency II and Basel II: a comparison of critical aspects 109 References 111 Glossary 113 Exhibits Exhibit 1: Breakdown of insurance premiums by line of business and geography Exhibit 2: Premiums per capita in life and non-life insurance (in USD, 2008) Exhibit 3: Chronology of the crisis – market developments 2007-2009 Exhibit 4: U.S. financial stress index – 2007-2009 Exhibit 5: Re-capitalisation and credit losses Exhibit 6: Rise and fall of wholesale funding and interbank lending Exhibit 7: Borrowing rates during the crisis Exhibit 8: Insurance pricing during the crisis Exhibit 9: Crisis impact by exposure to banking in operations Exhibit 10: Insurance companies affected during the crisis Exhibit 11: AIG revenues by division Exhibit 12: Monoliners’ exposures during the crisis Exhibit 13: Monoliners’ correlation to the housing markets Exhibit 14: Insurers’ cash-flows by source Exhibit 15: Operating net cash-flows and investments by major European insurers Exhibit 16: Estimated cash coverage of insurance companies Exhibit 17: Insurance debt issuance during the crisis Exhibit 18: Definitions of systemic risk and systemic relevance Exhibit 19: Economic capital by risk source Exhibit 20: Interconnectedness: insurance vs. banking Exhibit 21: Worldwide reinsurance capital inflows 1990-2008 Exhibit 22: Concentration of European primary insurance markets Exhibit 23: Concentration of the global and U.S. reinsurance markets Exhibit 24: Timing of World Trade Centre claims payments Exhibit 25: Approach for assessing systemic relevance Exhibit 26: Universe of activity categories carried out by insurance companies 7 8 11 12 13 13 14 14 15 16 17 19 19 20 21 21 22 23 24 25 27 27 28 28 33 34 iii Systemic Risk in Insurance—An analysis of insurance and financial stability Exhibit 27: Inter-connections of key risk activities in which insurers can engage 35 Exhibit 28: Insurers’ assets are significantly lower than banks’ assets and capital markets assets 36 Exhibit 29: Insurers’ exposure to other financial institutions 37 Exhibit 30: Insurers and the equity markets 37 Exhibit 31: Illustration of convexity mismatch 38 Exhibit 32: Example of impact of programme trading – Dutch pension fund hedge on euro long-term swap rates (December 2008) 39 Exhibit 33: Catastrophe losses vs. bank failures 41 Exhibit 34: Catastrophe loss coverage 42 Exhibit 35: Timing of insurance claim settlement – example of medical liability and World Trade Centre 43 Exhibit 36: Illustrative example: risk of jump in longevity (U.K.) 45 Exhibit 37: Case study on asbestosis 45 Exhibit 38: Effect of financial crisis on German life lapse rates 47 Exhibit 39: Allianz surrenders and financial resources (2008) 47 Exhibit 40: Illustration of reinsurance spiral 51 Exhibit 41: Comparison of insurance, reinsurance and retrocession gross written premium volumes 52 Exhibit 42: Cession and retrocession rates for major primary insurers and reinsurers 52 Exhibit 43: ILS market growth and insurers’ exposure to ILS 54 Exhibit 44: Evolution of weather derivatives 54 Exhibit 45: Liquidity risk from stock lending and commercial paper funding 56 Exhibit 46: Losses averted by bail out of AIG’s securities lending operations 56 Exhibit 47: Coverage of short-term liabilities by operational cash-flows and liquid assets 57 Exhibit 48: Overview of credit insurance market 59 Exhibit 49: Size, substitutability and interconnectedness of monoliners 60 Exhibit 50: AIG involvement in CDS and its interconnectedness to major banks 61 Exhibit 51: Example of disconnection between CDS notionals and underlying debt 62 Exhibit 52: CDS sellers and buyers by sector (December 2006) 62 Exhibit 53: AIG revenues 2005 by business lines 87 Exhibit 54: Size of top 10 European insurers compared to top 10 banks 93 Exhibit 55: Size of top 10 North American insurers compared to top 10 banks 94 Exhibit 56: Relative premium contributions by European countries for European top insurers 95 Exhibit 57: Equitable Life lapse rates 2000-2004 98 Exhibit 58: U.K. and Euro area GDP growth rates and U.K. pensioner income 99 Exhibit 59: National Australian economy and dwelling market 100 Exhibit 60: Pillar structure of Solvency II 103 Acknowledgements This Geneva Report is the product of a collective exercise comprising a steering committee, several working groups and many individual efforts that drafted and discussed all the texts plus a series of comments from outside experts and external support from Oliver Wyman—all under the auspices of The Geneva Association. It is part of a larger effort by The Geneva Association to stimulate and to conduct work on the credit crisis, new regulatory initiatives and their impact on insurance. iv Steering Committee Members • Aegon: Patricia Plas • Allianz: Volker Deville • Aviva: Jim Webber • AXA: Benoît Claveranne • Met Life: Stan Talbi • Munich Re: Jo Oechslin • Swiss Re: Raj Singh • The Geneva Association: Patrick M. Liedtke • Zurich Financial Services: Axel P. Lehmann Working Group Members • Aegon: Christian Pierotti, Patricia Plas • Allianz: Michael Buttstedt, Arne Holzhausen • Aviva: Hugh Francis, Tim Hall, Nick Kitching, • AXA: Benoît Claveranne, Fabrice Lorillon • Generali: Gianfranco Vecchiet • Lloyd’s: Alastair Evans , Gavin Steele • MAPFRE: Luigi Lubelli • Met Life: Lori Evangel, Susan Greenwell • Munich Re: Matthias Kubicek , Michael Menhart • Partner Re: François Vilnet • Prudential plc: Miles Celic, Sven Kasper, Paulette King, Sally Padget • Prudential Financial: Elisa Puzzuoli • SCOR: Philippe Trainar • Sul America Seguros: Oswaldo Mario • Sun Life Financial: Claude Accum • Swiss Re: Philippe Brahin, Astrid Frey, Thomas Hess, Karen Hudson • The Geneva Association: Patrick M. Liedtke, Jan Monkiewicz • Tokio Marine: Makoto Hori, Masaaki Nagamura • TrygVesta: Martin Bøge Mikkelsen • Vittoria Assicurazioni: Andrea Acutis • Zurich Financial Services: Peter Buomberger, Daniel Hofmann, Roy Suter The Geneva Association thanks Oliver Wyman for the external support. External Support • Oliver Wyman: Alexandre Carrion, Claudia Fell, Bernhard Kotanko, Andrew Rear v Systemic Risk in Insurance—An analysis of insurance and financial stability vi