Editorial Board

Insuring Against the Risk From Insurance

The industry did better than banks in the crash, but next time could be different.

It can be a hazardous business.

Photographer: Dan Kitwood/Getty Images

Compared with the banks, insurance companies withstood the calamity of 2008 pretty well. American International Group Inc. was the main exception -- it needed an enormous bailout -- but the rest of the industry was spared the worst. Does this mean that insurance companies pose no great challenge for financial regulators?

It doesn't. The insurance business is posing a bigger systemic risk than it used to. Regulators need to pay closer attention.

For years, life insurers promised policy-holders guaranteed returns. When interest rates came down, some companies (notably in Germany) struggled to deliver. Managers responded by taking on more risk. They've invested in riskier bonds and less-liquid assets, including infrastructure projects, which are harder to sell in the event of a crisis. 

These trends are grounds for concern. Insurance companies may face liquidity pressures if a lot of policy-holders cash in their contracts at once. Some of the firms are extremely large and connected in complex ways to other parts of the financial system. As AIG showed, this can create a version of the "too big to fail" syndrome that demands additional scrutiny of systemically important banks. 

Regulation of the insurance industry is relatively relaxed. For example, insurers aren't required to mark all their liabilities to market. This makes some sense, because companies don't typically redeem these liabilities on short notice. Nonetheless, insurers are vulnerable to market shocks.

The International Monetary Fund recently simulated the impact of a shock in the equity and real-estate markets and of a flight to high-quality sovereign bonds. It found that the insurance business would be severely affected. "If such a shock were to occur," it reported, "it could mean that life insurers would be unable to fulfill their role as financial intermediaries, precisely when other parts of the financial system are failing to do so."

Regulation in the industry has evolved since the crash, but the assessment of risk needs further improvement. Data is lacking, and it's harder than it should be to compare liabilities across countries. The U.S. makes banks submit to regular stress tests, but makes no such demand of insurers. There's a harmonized international regime for setting capital standards for banks, but not for insurers.

This needs to change. Better and more fully comparable data is essential; attention should be paid to the need for bigger capital buffers; and, as long as solvency remains an issue, regular stress tests would be wise. The effort needs to be international. And the time to look at this more carefully is now -- before, not after, the next financial crisis.

    --Editors: Ferdinando Giugliano, Clive Crook

    To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net .

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