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Scope of data shows wide picture of any systemic risk

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From the way that a key executive board member of the International Association of Insurance Supervisors (IAIS) and the Basel Committee of Banking Supervision views globally systemic risk, it appears that some insurers are considered to be systemically risky in a very broad sense of the term.

Paul SharmaIn remarks at the NAIC international forum in Washington last week and in remarks to a reporter, it is clear Paul Sharma, executive director of policy and deputy head of the U.K.’s Prudential Regulation Authority (PRA), believes he sees facets in the giant prism of economic risk that many do not see or mention in general public discussions.

First, most regulators, let alone insurers, are not privy to both banking and insurance confidential financials, which are much more extensive than what is available publicly. 

The world’s banking regulators cannot peer into the confidential insurance metrics of global systemically important insurers (G-SIIs) candidates nor can the IAIS look at any confidential bank metrics. 

But, as a pan-sector financial regulator, who also chairs a Financial Stability Board (FSB) working group, Sharma is one of the few, as he acknowledges, who can see both the financial metrics of both banks and insurers, but because they are confidential, he cannot share what he knows. 

He made it clear, though, that the rest of the financial sector, industry and regulators, are not seeing the whole picture, and that there is more systemic risk to be discussed when and if everyone can access the same metrics. A lot of the disconnect in the debate of insurers’ versus banks’ systemic risk, he suggested, was coming from people having access to only subsets of data, Sharma said at the NAIC forum on May 10.

For example, he noted afterwards, most cannot see the gross notional values of derivatives as end users of derivatives or see gross as net, according to Sharma.

Some global insurers have argued that banks carry much more gross derivative exposure than insurers, on average.

But even when an insurance company risk is in nontraditional insurance, it can look quite differently than banks participating in the same arena, Sharma said, who was once a specialist insurance regulator.

Also, Sharma explained in the forum, and afterward, concerns with competitive trading questions and imbalances that could cause systemic risk if a bank is systemically important but an insurer is not. He used the example of a derivatives trader that is a subsidiary of an insurance group competing with the derivatives trader of a systemically important banking group. This imbalance in competitiveness “is potentially made worse if we just designate banking groups and not just insurance groups,” he said.

The imbalance, he explained in a chat afterward, could exacerbate the credit cycle, and make things more volatile.

Practices that are strongly encouraged in calm times and strongly discouraged in other times also tend to be systemically risky, Sharma said.

There are some forms of asset transformation, of gaps between promises made on one hand  in the insurer’s sale of long-term investment products and those taken on the other, that you would not even see in the banking center, he said in the public forum.

Sharma chairs the IAIS’s Financial Stability Committee, the influential committee that will choose the potential G-SIIs for review by the G-20‘s Financial Stability Board (FSB). As such, he is one of the key people detailed to the final list of G-SII candidates. A final determination of the first crop of G-SIIs may come next month, a delay from April.   

The committee is vice-chaired by the NAIC’s Elise Liebers. Over at FSB, Federal Reserve Governor Daniel Tarullo is now chairman of the FSB’s standing committee on supervisory and regulatory cooperation (SRC), acting as a sort of traffic controller for the G-SII candidate list once it enters FSB airspace, among other things. 

 The “list” has been the subject of much debate internally and externally. 

In April, the PRA became responsible for the prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms — around 1,700 financial firms total.

Sharma debated other panelists who all argued, by turns, that their company, or in the case of Swiss Re, their industry – reinsurance – is not systemically risky, that the state -based insurance system works, that they believe in group-wide supervision and that they do now know what it will be like to be a G-SII if they are designated one, but they do not think any positive will outweigh the negatives. 

Swiss Re has been “spotlighted” as a potential G-SII, said Swiss Re chief economist Kurt Karl at the session.

The state-based system has worked very well, asserted Gen Re’s General Counsel Damon Vocke. There has been no contagious event within the insurance company regimes and the NAIC is always improving system with enhancements, Vocke said.

With international companies, “we believe supervisory colleges are a prudent and appropriate vehicle. We have had two to face, another one coming up. All our regulators are invited. It is a very robust and comprehensive discussion. It is a “terrific way to do top-down analysis,” Vocke said. “There is no historical evidence that insurers, on their own pose, systemic risk.” He added that he does not think parent Berkshire Hathaway is on the G-SII candidate list.

But, most companies and sector regulators can only see a slice of metrics in the public domain driving insurance risk, Sharma suggested in his remarks. 

When and if the banking and insurance complete financial metrics are in the public domain, you will be able to see much more clearly the comparability of risk, Sharma told the audience of state regulators, federal officials and industry executives and lobbyists.

With more disclosure, we will be able to have a more coherent, public debate on this, Sharma said on the panel devoted to addressing financial stability in the insurance sector.

Later, he said there are many nondisclosed financial data that are confidential but suggested  these metrics matter, even though they are not seen as material to be reported publicly by the insurance company.

Sharma is not saying that insurers look especially systemically risky now, as they claim not to be, but is looking forward to a more tumultuous time.  

Practices that are rational for an insurer and safe for the policyholder or good for investors may be systemically risky because of their impacts on other sectors, Sharma explained.

During a tumultuous time, Sharma posited, does the insurance company have a strategy that it can execute that can reduce its own possibility of default, and what are the consequences of executing that strategy? 

In an example, Sharma used an analogy involving a twin engine airplane flying with cargo. If one engine fails, cargo is unloaded — it is good for the plane — but  what about the people on the ground below being hit with the offloaded cargo?

Given sufficiently benign circumstances — probably very few institutions, banks and nonbanks,  would be systemic, or have systemic consequences, he said. But in a more tumultuous time, “what else would be occurring at the same time? If you take an institution like that — what else would be going on at the same time — quite a lot else would be going on,”  Sharma said.

Also, there is need to consider the whole group, and the noninsurance parts of the group. Sharma said in conference remarks that these activities matter and can sometimes matter profoundly, and more significantly, than would occur if they were occurring in a completely unconnected stand-alone place.

Later, panelist Terri Vaughan assessed his point of view.

There are some who would say, let’s designate some companies to keep a closer eye on them, just in case things could go wrong, to be on the safe side, said the former NAIC CEO and international regulatory affairs expert on behalf of the U.S. states. 

“I strongly believe that these well-intentioned efforts could carry tremendous unintended consequences for the insurance sector,” said Vaughan, who now sits on a few company boards.

Vaughan also said it was impossible to rebut an argument based on information no one else can access or analyze.

“If they are really seeing something that is so important to this systemic risk discussion, they should be willing to lay it out more clearly for a public discussion. Different people may interpret data differently,” Vaughan said.

 If the argument is that just because the insurance sector performed well in this crisis doesn’t mean the next time won’t be different, that is also impossible to rebut, she said.

“But the fact is that we have had centuries of banking crises. The insurance sector has long been different, and we need more justification if we are going to make potentially very problematics changes in how we regulate,” Vaughan said.

Sharma said it will be hard to be designated a G-SII without nontraditional, noninsurance activities (NTNI) in the IAIS parlance.

At the end of April, the IAIS committee heads met in London to discuss NTNI, on which Sharma has been lobbied very hard.

For example, life insurance as an industry is arguing against classifying variable annuities as nontraditional insurance. 

Some argue these nontraditional activities are often accounted for as insurance on balance sheets. Securities and third party asset management are examples of noninsurance (NI).

These and other “nontraditional activities” are discussed in the IAIS proposed methodology. 

“It would be hard to designate companies as a G-SII without it having NTNI, Sharma said, pointing to NTNI’s weighting of up to 50 percent in judging G-SII candidates.

The IAIS has stated that G-SIIs are most likely to take the form of a group and NTNI are often carried out by separate entities within a group and/or the group may have significant interconnections to other parts of the financial system.  

There won’t be higher capital requirements for traditional insurance businesses in a G-SII insurer, Sharma said. 

There will be a higher loss absorbency required for NTNI activities, but it will be on a sliding scale of percentage increases that rises the more interconnected an insurer is, Sharma said. Those amounts have not been decided yet, though, he said.

“It would be a mistake to designate companies and not have consequences,” Sharma said

He added that he has never been lobbied so much in his life as he has by companies trying to get off the G-SII candidate list. No one wants to be on the list, he acknowledged. They want to get off of it, he said.


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