Insurance: A unique sector
The Maltese insurance industry may be considered to be a new kid on the block compared to some of the other components of the financial services industry in Malta. To its credit the industry seamlessly continued to offer its services to the public throughout the financial crises and it therefore has an interest to ensure that any changes in the regulatory regime that come about as a reaction to the recent crises are in fact sector specific in the interest of that sector and are not put in place as a “one size fits all”.
The growth of the Maltese insurance sector has been quite dramatic over the recent past as can be seen from the statistics published by the MFSA, it is therefore in the interest of all of us that insurance continue to play its part in the economic development of the country in a appropriately regulated manner.
The CEA, the Association of European insurance associations, of which the Malta Insurance Association is an active member, has recently published its opinion in regard to these regulatory propositions which is not directed towards the banking industry but rather towards those who regulate financial services. We do not believe it to be correct for the broad brush approach to be taken as a matter of principle and this position is being made clear in the interest of future financial stability all round.
The impact of the financial crisis hit the financial sector and economies overall extremely hard. Asset writedowns and lower investment returns destroyed billions of euro in market capitalisation in just a few months, forcing governments – and hence taxpayers – into unprecedented bail-outs and triggering a spike in sovereign leverage.
In reaction, policymakers are pushing for fundamental reforms to the way the financial services sectors are regulated and supervised. Regulatory intentions are focusing not only on preventing or at least mitigating a further crisis, but also on avoiding government intervention to contain its effects. This is not surprising. During the recent crisis, G-20 governments and central banks provided more than $11,000 billion of direct and indirect support to the financial services sector, although less than $10 billion (with the exclusion of one specific case where the loss was not related to the core insurance business) went to the insurance sector.
It is, of course, vital to learn lessons after a crisis, especially one that sent such shockwaves through the entire interconnected global economy. The insurance industry naturally supports sound and stable financial markets. After the crisis, policymakers generally started to develop reforms to address problems in the banking sector. A worrying trend has, however, emerged. Several regulatory initiatives ultimately read across into other financial sectors, and do not appropriately distinguish between the distinct business models of the different sectors.
For example, policymakers are considering more stringent micro-prudential regulation, such as higher capital requirements, and more onerous regulation of “systemically relevant institutions”. In addition, the International Monetary Fund published in April 2010 an interim report proposing taxes or levies on all financial services institutions to recover the costs of repairing the banking system and to finance the future costs of winding up failing firms.
The assumption is that what is valid for banking must be valid for insurance.
This assumption is wrong.
Insurance was neither at the root of the crisis, nor the main recipient of government support. Banks and insurers played quite different roles during the crisis because they operate on very distinct business models and therefore have very different risk profiles, both at micro-prudential level (i.e. the stability of individual institutions) as well as at macro-prudential level (i.e. the stability of the financial system overall and its impact on the economy.
The core activity of insurers is risk pooling and risk transformation, while that of banks is the collection of deposits and the issuing of loans, together with the provision of a variety of fee-based services.
At micro-prudential level, insurance companies usually have more stable, up-front and long-term funding, a simpler balance –sheet structure and significantly lower exposure to liquidity risk. Insurance assets and liabilities are generally linked, while banks often have to deal with a structural mismatch of assets and liabilities which makes the risk of excessive leverage significant. The ownership and transparency of risks assumed are similar in insurance and conventional retail or corporate banking, but are lower in some non-core banking activities.
The interconnectivity between institutions is a core part of the banking business model (in particular due to interbank lending), whereas in insurance it is very low. On average, capital volatility is higher in banking. The investment approach in insurance is more long-term and driven by more predictable liability than the more short-term and asset-driven approach in banking.
As a consequence, the risk profiles of insurance companies and banks differ fundamentally. The core of the insurance business model is the diversification of risk in the portfolio and over time. This determines insurers’ long-term risk profile, in contrast to the more short-term risk profile of banks.
Insurance companies are mainly exposed to underwriting and market risk and relatively benign liquidity and credit default risk. Banks are mainly exposed to liquidity, market and credit default risk but have no exposure to insurance underwriting risk. The type of exposure to market risk varies. Market risk is severe for both banking and insurance, but fundamentally different in its components, such as the substantially lower asset liability mismatch risk in insurance.
Both banks and insurers are considered financial intermediaries. However, insurance companies and banks play quite different roles in relation to the efficient functioning of the whole economy. Banks provide leverage to the economy and are part of the payment and settlement system. As such, banks transmit to the economy the monetary policy of central bank. Insurers, on the other hand, make an important contribution to economic growth by providing consumers and businesses with protection against negative events. However, while this role is critical for the functioning of the economy, insurers undertake their role as financial intermediaries in a far less directly connected manner with respect to the whole economy.
At macro-prudential level, based on the criteria for the identification of systemic risks drawn up by the Financial Stability Board and the international Association of Insurance Supervisors, the core insurance business model does not generate systemic risk that is directly transmitted to the economy. There is far lower contagion risk, higher substitutability and lower financial vulnerability than in banking.
The financial position of insurers deteriorates at a much slower pace than that of banks, and the insurance regulatory framework sets two levels of capital requirements to ensure the early detection of financial problems and the application of progressive corrective action by management and supervisors.
Even when an insurer does fail, an orderly wind-up is much easier, since insurers strive to match expected future claims by policyholders with sufficient assets (technical provisions), which facilitates the transfer or run-off of their portfolios.
However, some insurance companies in the larger markets may undertake a limited number of non core activities that may be systemically relevant (eg. derivatives trading or securities lending). These cases can be addressed by micro-prudential regulation. Finally, as large institutional investors, the insurance sector as a whole may transmit or – as demonstrated during the current crisis – absorb systemic shock or risk generated by other parts of the financial system.
The CEA, the European insurance and reinsurance federation, supports appropriate improvements to regulatory and supervisory standards for insurers that will maintain a sound and competitive insurance industry and foster consumer confidence. Exporting to the insurance sector the regulatory reforms and tax proposals under consideration post-crisis for the banking industry would be the wrong regulatory response to problems that in insurance are either non-existent or small. Imposing a banking regulatory and supervisory framework on the insurance sector would trigger “herd” behaviour; driving all financial services sectors to behave in the same way. This would result in a permanent weakening of the insurance business model, damaging the potentially stabilising role insurance plays for individual citizens, businesses and the economy.
The continuing existence of different business models, fostered by appropriate, tailored made regulation and supervision, creates the market diversity that underpins overall financial stability. Concerns about regulatory arbitrage can be addresses effectively while still improving the supervisory and regulatory framework of the insurance industry in a sector-specific way.
The author is managing director of GasanMamo Insurance Ltd and president of the Malta Insurance Association.