INSURANCE, SYSTEMIC RISK
& THE FINANCIAL CRISIS
Faisal Baluch, Chris Parsons & Stanley Mutenga
Cass Business School, City of London
1
1
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
2
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
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3
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
4
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
 Lloyd’s near-collapse 1988-92
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5
INSURANCE ‘CRISES’

Typically short, local and limited in their
effects

Never a world-wide ‘insurance crunch’
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6
LESSONS FROM HISTORY 1 - LOYD’S CRISIS 1988-92

Massive losses – mainly on US liability
business (asbestos, pollution, med-mal)

‘Names’ (investors) pulled out so
capital disappeared

Lloyd’s 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)
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7
LESSONS FROM HISTORY 1 - LOYD’S TODAY

Lloyd’s came through the Crisis almost
unscathed

Has focused on core insurance business
and risks it understands

Very little exposure to equity markets
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8
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
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9
LIABILITY INSURANCE

Lines most affected are Errors and Omissions
(E&O) and Directors and Officers insurance
(D&O)

Estimated losses US$9.6bn, ($5.9bn for D&O,
$3.7bn for E&O (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 D&O
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10
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
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11
LESSONS FROM HISTORY 2
CUTHBERT HEATH’S ‘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.’
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12
Cuthbert Eden Heath OBE
1859-1939
Insurance businessman
Founder of CE Heath Ltd
IIS Hall of Fame
Induction Year 1966
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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)
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14
EFFECT ON INSURANCE MARKET STRUCTURE

Some insurers needing to raise fresh capital

Smaller/weaker firms vulnerable to M&A 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?
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15
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/investment 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
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16
BRITISH BANKERS APOLOGISE FOR THE FINANCIAL CRISIS …. (A LITTLE)
Read more: http://
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Returns on S5BANKX INDEX
Returns on S5INSU INDEX
-10.00%
-20.00%
-30.00%
18
02/11/2009
02/09/2009
02/07/2009
02/05/2009
02/03/2009
02/01/2009
02/11/2008
02/09/2008
02/07/2008
02/05/2008
02/03/2008
02/01/2008
02/11/2007
02/09/2007
02/07/2007
02/05/2007
02/03/2007
02/01/2007
02/11/2006
02/09/2006
02/07/2006
02/05/2006
02/03/2006
02/01/2006
02/11/2005
02/09/2005
02/07/2005
02/05/2005
02/03/2005
02/01/2005
02/11/2004
02/09/2004
02/07/2004
02/05/2004
02/03/2004
02/01/2004
Banking and Insurance Stocks Returns for period 2004 -09
30.00%
20.00%
10.00%
0.00%
FTIC Index
FTBK Index
BBG WORLD BANKS INDEX
02/11/2009
02/09/2009
02/07/2009
02/05/2009
02/03/2009
02/01/2009
02/11/2008
02/09/2008
02/07/2008
02/05/2008
02/03/2008
02/01/2008
02/11/2007
02/09/2007
02/07/2007
02/05/2007
02/03/2007
02/01/2007
02/11/2006
02/09/2006
02/07/2006
02/05/2006
02/03/2006
02/01/2006
02/11/2005
02/09/2005
02/07/2005
02/05/2005
02/03/2005
02/01/2005
02/11/2004
02/09/2004
02/07/2004
02/05/2004
02/03/2004
02/01/2004
Perfomance of Banks and Insurance Companies During the
Financial Crisis
200%
180%
160%
140%
120%
100%
80%
60%
40%
20%
0%
BBG WORLD INSURANCE INDX
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19
DJ AMBST GLB REINS INDEX
DJ AMBST ASIPAC INS INDEX
DJ AMBST US LIFE INSURANCE
DJ AMBST US PRP CAS INDEX
DJ AMBST GL INSR CMP INDEX
DJ AMBEST EUR INSR INDEX
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22/01/10
22/12/09
22/11/09
22/10/09
22/09/09
22/08/09
22/07/09
22/06/09
22/05/09
22/04/09
22/02/09
22/03/09
22/01/09
22/12/08
22/11/08
22/10/08
22/09/08
22/08/08
22/07/08
22/06/08
22/05/08
22/04/08
22/02/08
22/03/08
22/01/08
22/12/07
22/11/07
22/10/07
22/09/07
22/08/07
22/07/07
22/06/07
22/05/07
22/04/07
22/02/07
22/03/07
22/01/07
22/12/06
22/11/06
Perfomance of Insurance Companies During The Financial Crisis
140%
120%
100%
80%
60%
40%
20%
0%
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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 noncorrelated 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
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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).
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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
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WHAT HAS CHANGED?
• Expansion of bancassurance
• Insurers big players in the derivative market
(namely CDS)
• Insurers and banks connected via funding
channel (Capital Market)
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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 US$60 Trillion

Big ‘insurance’ losers on CDS include US monolines (e.g.
AMBAC, MBIA, CIFG Guaranty), Swiss Re, AIG

AIG’s mainstream insurance business relatively sound

CDS not ‘insurance’ for regulatory purposes – much of the
market for CDS has been unregulated posing CDA risk
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REINSURANCE AS A FORM OF SYSTEMIC RISK
The sector faces the following risks via Reinsurance
1. Credit Risk - Possibility of default by Reinsurer
2. 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
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REASONS FOR INSURANCE COMPANY FAILURE
(US PROPERTY/CASUALTY) 1969 - 2005
Inadequate pricing or
loss reserves 38.2%
Too rapid growth 16.5%
Alleged fraud 8.6%
Catastrophic losses
6.5%
Affiliate problems 5.6%
Investment problems
7.3%
Miscellaneous 9.2%
Significant change in
business 4.6%
Reinsurance failure
3.5%
Source: A.M. Best
27
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
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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
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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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