There are 18 indicators (added at end) grouped into five weighted categories which the global insurance supervisory body will use to assess insurers in order to determine whether they are systemically risky, according to a paper released today.
The largest consideration will be given, by far, not to size but to nontraditional insurance activities and interconnectedness, according to a breakdown of all factors released by the International Association of Insurance Supervisors (IAIS) today.
The IAIS proposed assessment methodology for identifying global systemically important insurers, or G-SIIs (loosely referred to as G-SIFIs in the States) as part of a long process to reduce the risk of a financially cataclysmic insurance failure.
The companies identified would be subject to heightened controls and likely higher reserves and core capital or financial standards.
Non-traditional and non-insurance activities are important, the IAIS noted, because the longer time frame over which insurance liabilities can normally be managed is not a necessarily a feature with non-insurance-type activities, and interconnectedness is important because there can be strong connections between the insurance and banking sectors.
The paper was endorsed for consultation by the Financial Stability Board (FSB), which is coordinating the overall set of measures to reduce the moral hazard posed by G-SIFIs. Supervisors, insurers and other interested parties are encouraged to submit comments on the proposed methodology through 31 July. At the request of the G20 Leaders and FSB, the IAIS has been developing the G-SII assessment methodology and policy measures.
The IAIS calls itself a global standard setting body whose objectives are to promote effective and globally consistent regulation and supervision of the insurance industry–its membership includes insurance regulators and supervisors from over 190 jurisdictions in some 140 countries.
The selected indicators are weighted, as well, within the five categories, the IAIS paper stated.
The five G-SIFI assessment categories are:
- · Size: The importance of a single component for the working of the financial system generally increases with the amount of financial services that the component provides. It should be recognized, however, that in an insurance context size is a prerequisite for effective pooling and diversification of risks. Only 5% to 10% weighted as a category.
- · Global Activity: The methodology is aimed at identifying components of the financial system whose failure can have large negative externalities on a global scale. Only 5% to 10% weighted as a category.
- · Interconnectedness: Systemic risk can arise through direct and indirect inter-linkages between the components of the financial system so that individual failure or distress has repercussions around the financial system, leading to a reduction in the aggregate amount of services. Its weighting is 30% to 40% as a category in determining G-SIFIs.
- · Non-traditional and non-insurance activities: This is the juggernaut of international regulatory consideration by far by the IAIS. Its category weighting is 40% to 50% in the G-SIFI assessment. It even includes variable annuities, the rationale being that variable annuities most often include some type of guaranteed levels of payment to policyholders: attempting to pay guaranteed amounts could accelerate asset sales by an insurer and exacerbate already distressed market conditions. There is also the possibility that hedging strategies for guarantees could adversely affect markets in times of wider market stress, the IAIS stated.
In developing the insurer-specific methodology, the IAIS referred to its November 2011 report Insurance and Financial Stability, which concluded that there is little evidence that traditional insurance either generates or amplifies systemic risk within the financial system or in the real economy. However, non-traditional insurance activities and non-insurance financial activities are potential drivers of the systemic importance of insurers and thus have the greatest impact upon failure, the IAIS has stated.
- · Substitutability: The systemic importance of a single component increases in cases where it is difficult for the components of the system to provide the same or similar services in the event of failure.
The size, global activity and substitutability categories are given lower weights because risk diversification benefits go in tandem with greater size of traditional insurance activities and global spread, and substitutability is typically met with the speed with which loss of insurance capacity is replaced by new entrants into the market, according to the IAIS
Also, in addition to the 18 indicators above, the final methodology will most likely incorporate additional indicators, including:
- · The amount of derivatives trading without hedging purposes in economic terms.
- · The extent of liquidity of insurance liabilities (that is, the degree of those liabilities that are callable on demand or at short notice).
For each insurer, the score for a particular indicator is calculated by dividing the individual insurer amount by the aggregate amount summed across all insurers in the sample for a given indicator.
This indicator-based assessment approach is related to the Basel Committee’s methodology for banks. However, the specific nature of the insurance sector, as described in Insurance and Financial Stability, has influenced the selection, grouping and weights assigned to certain indicators, the IAIS stated.
To capture impact given failure, indicators are mostly incorporated as absolute value figures, although in some cases ratios are also used to capture a relative impact given failure, typically comparing the size of a given activity with a relevant aggregate measure.
Federal Insurance Office (FIO) Director Michael McRaith has said a number of times that the FIO and the treasury-led Financial Stability Oversight Council (FSOC) intends to coordinate with the IAIS on SIFI and G-SIFI designations. Unlike the IAIS, the FSOC has statutory considerations it must cleave to. The FSOC released its criteria for determining domestic nonbank SIFIs which would then fall under Federal Reserve Board prudential supervision almost two months ago.
“Our approach should be consistent with the FSOC…We have constant dialogue between FSOC group and our group, I assume it will be a very consistent approach,” said the IAIS secretary general Yoshi Kawaii on a panel at a recent NAIC forum in Washington in early May. “We work hard moving toward the same direction,” he said later in the press conference earlier this month.
Meanwhile, company data collection continues flowing from U.S. insurance companies to the IAIS, with the state of Connecticut acting as a conduit of confidential information from U.S. insurers to the IAIS. Connecticut has a statute protecting the confidentiality of information. After it is collected and passed through, it is immediately erased.
The FSOC’s criteria are applied in a three-phase process of review. The FSOC uses uniform quantitative thresholds to identify nonbank financial companies for further evaluation and has a six-category framework to consider whether a nonbank financial company meets either of the statutory standards for a determination, including examples of quantitative metrics for assessing each.
FSOC will examine as its criteria or indicators:
- The extent of the leverage of the company;
- The extent and nature of the off–balance-sheet exposures of the company;
- The extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
- The importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the U.S. financial system;
- The importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
- The extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
- The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
- The degree to which the company is already regulated by one or more primary financial regulatory agencies;
- The amount and nature of the financial assets of the company;
- The amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and anything else.
The FSOC took these 10 statutory considerations and dropped them into an analytical framework consisting of the following six categories, which overlap with IAIS but are not publicly weighted, as are the IAIS standards:
- Liquidity risk and maturity mismatch, and
- Existing regulatory scrutiny
Three of these six categories seek to assess the potential impact of a nonbank financial company’s financial distress on the broader economy: size, interconnectedness, and substitutability, FSOC interpretive guidance stated.
The remaining three categories seek to assess the vulnerability of a nonbank financial company to financial distress: leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny.
Currently, FSOC is still in stage one of its assessments for SIFIs, or was a few weeks ago.
This first stage of the process (“Stage 1”) is designed to narrow the universe of nonbank financial companies to a smaller set of nonbank financial companies–said to be about 50, including some insurers. FSOC is now evaluating nonbank financial companies by applying uniform quantitative thresholds that are broadly applicable across the financial sector to a large group of nonbank financial companies.
These Stage 1 thresholds represent the framework categories that are more readily quantified: size, interconnectedness, leverage, and liquidity risk and maturity mismatch. Substitutability is not one of these.