Insurance and financial stability: a Basel view
Prepared remarks by Jaime Caruana, General Manager of the Bank for International Settlements, before the International Association of Insurance Supervisors, Bottmingen, Switzerland, 20 March 2013.
BIS General Manager Jaime Caruana speaks about the importance of the work that the International Association of Insurance Supervisors and the supervisory community are undertaking.
He highlights three major challenges:
- cooperation among different supervisors;
- the conceptual challenge of coping with systemic risk; and
- the economic environment, including the deterioration of the creditworthiness of many sovereigns and the protracted low rate environment, known as "low for long".
Thank you, Peter, for that kind introduction, and good evening, ladies and gentlemen. It is my pleasure to be here with you this evening and to speak with you about the importance of the work that the IAIS and the supervisor community are undertaking.
The BIS has had the pleasure and privilege of hosting the IAIS since its move to Basel in 1998. Since then, the IAIS has widened its objectives to become the global insurance standard setter and the global insurance voice with regard to matters of financial stability, and has thus become a key element of what we call the Basel Process.
Tonight I will highlight three major challenges. Cooperation among different supervisors is the first of these challenges, and in this context I would like to say a few words about the Basel Process.
The second is the conceptual challenge of coping with systemic risk. In my view, this requires awareness of our own limitations in understanding, measuring and managing systemic risk in a complex world. This, in turn, puts a premium on being prepared for the unexpected.
The third group of challenges is posed by the economic environment. It includes the deterioration of the creditworthiness of many sovereigns and the protracted low rate environment, known as "low for long."
1. Let me start with the first challenge, related to cooperation among supervisors. I would like to stress the importance of the work of the IAIS as a key element of global cooperation, and the Basel approach.
It is fair to say that the most important aspect of the global policy response to the crisis has been the strengthening of financial regulation. This has taken place mainly on the banking front, but as we all know the insurance sector also plays a crucial role in the global financial system and in the long-term financing of the economy. I am glad to note that the IAIS has been at the forefront of these efforts in the insurance sector.
I would like to say a few words about what we call the Basel Process. The Process is based on various features. One is the physical proximity of independent financial stability committees, such as the BCBS, the IAIS and the FSB, hosted by the BIS, and the resulting synergies among them. Each standard setter brings its expertise in different business models and its own independent governance process. BIS contributions are also important in terms of research and banking experience. Yet another important aspect of the Basel Process is the dissemination of financial stability work to the broader public. By putting together all these elements, we can generate synergies and better coordination in a flexible environment. The BIS is very happy to host the IAIS and to ensure its full participation in the Basel Process.
2. From a conceptual point of view, we need to understand our limitations in managing risks. What are the main lessons we have drawn from the crisis?
A first lesson is that we know much less than we thought we knew. Moreover, the financial system is constantly, and rapidly, evolving.
- I worry that our efforts to fix the various deficiencies unveiled by the last crisis run the risk of fighting the last war. We need to be aware of our limitations and be prepared for the unexpected.
- To be prepared, we need to have ample buffers. We need to have more robust financial institutions, with a solid capital base and a strong liquidity position.
- I think this is an important lesson that has certainly been driving the regulatory agenda for banks. But it can also be applied more specifically to insurance. I know it is a difficult issue under discussion, and it takes time, but there is merit in establishing a global capital standard for insurers. After all, one might argue that you cannot effectively supervise globally active firms without having a consistent, comparable quantitative standard.
- Certainly, insurance is different, and, except for some non-traditional insurance business, the sector has proven quite resilient. But we need to remember that the intervention of the authorities was huge, involving a cumulative increase in government debt as a share of GDP of more than 30 percentage points for the OECD area since 2007 and massive liquidity interventions by central banks. The counterfactual about the resiliency of the financial system is difficult to formulate, and it is hard to know how more resilient business models would have weathered the crisis in the absence of these large-scale policy actions.
A second lesson relates to SIFIs:
- Significant progress has already been made regarding large global banks. I understand that there are important differences between the business models of banks and insurers, but I am convinced that the same rationale can be adapted to other industries.
- This is why we fully support the IAIS in developing a methodology for identifying global systemically important insurers - or G-SIIs - and for asking them to build up more capital.
- I understand that you spent some time today discussing one potential policy measure for G-SIIs - Higher Loss Absorption capacity, or HLA. It is very important to finalise the work on how this HLA should be calculated and, perhaps more importantly, on how it should be applied.
A third lesson of the crisis is that regulation itself is not sufficient if it is not properly enforced in a timely and consistent way across all jurisdictions. Actual implementation of the standards had a great bearing on the severity of the crisis across countries.
- This is why I think that the IAIS contributes importantly to global financial stability by playing a key role in promoting effective, independent and globally consistent insurance supervision.
- As always, the devil is in the details. Good supervision requires strong political commitments and adequate resources, at both the national and the international level. Most importantly, it also requires dealing effectively with cross-border issues.
And a last lesson is that we need a regulatory approach that is consistent across the main jurisdictions and sectors, as financial firms are becoming more and more interconnected.
- The crisis showed that the impact of the failure of a single institution can be felt all over the world and in various sectors.
- Developing the ability to communicate and coordinate across borders is more important than ever. In particular, I understand that the IAIS ComFrame project is specifically seeking to address the myriad of complex issues that confront supervisors of internationally active insurance groups. I cannot profess to know about all of the intricacies of ComFrame, but I do strongly support its aim.
- Coordination across financial sectors is also important, which is why the participation of the IAIS in the Basel Process is so essential, as I mentioned at the outset.
3. Let me now turn to the third part of my intervention today, current economic challenges. We need to integrate our work on financial regulation into a broad macro perspective.
The BIS has for many years - including well before the crisis - stressed the importance of looking at supervision and regulation through a macroprudential lens.
To keep the financial system, or any sector of it, from instability requires
- not just that we get regulation right; and
- not just that we get supervision right.
These are necessary but not sufficient conditions. Financial stability cannot be achieved without a healthy economy and good macroeconomic policies - for instance, by promoting monetary stability, which as you know is in the genes of the central bankers that meet at the BIS.
From the standpoint of the insurance business, two underlying economic threats have emerged since the global financial crisis, which are all too clear and all too present to me:
- The first is the deterioration of the creditworthiness of many sovereigns.
- The second is very low long-term bond yields.
Granted, these threats vary in intensity across the jurisdictions represented here. But they are common threats.
As regards the first issue of sovereign risk, we must recognise that, as financial firms with long-duration liabilities, insurers and pension funds need long-duration assets.
- They have long looked to government bonds as their core holdings to match liabilities.
- In addition, they have raised returns, typically at shorter maturities, through investment carrying considerable credit risk.
- Insurers benefited from governments taking on debt during the crisis in order to limit private credit risk - think of insurers' holdings of bank bonds - but they now face the consequences of high and still rising government debt.
- Thus, risk managers in insurance companies are re-examining their basic business model. In particular, they are asking awkward questions about insurance companies' ability to survive the distress of any sovereign to which they are exposed.
I am convinced that we do not want to learn how to live with elevated sovereign risk and that governments need to take the difficult steps to re-earn a practically risk-free status through credible fiscal consolidation plans that work over the long run. Central bankers and insurers alike need to push for a return to sustainable government finances.
A second threat to insurers' business model is "low for long" bond yields. This threat has several aspects:
- Low rates for long can put solvency pressure on those life insurers that have committed to delivering too-high returns for policyholders.
- There is a risk that competitors will simply reach for yield and not adjust their pricing of annuity-type products sufficiently, and that business will shift to those most willing to take risks.
- And even if the industry does adjust its pricing appropriately, customers may go elsewhere, hurting revenues while leaving operating costs.
- But if customers do go elsewhere, who will provide the long-term financing needed by the real economy? Any cutback in such financing would undermine long-term growth prospects and financial stability.
Low rates can buy some time but cannot solve some of the problems the world economy is facing. This requires repairing balance sheets, achieving sustainable public finances and implementing reforms that spur growth. Unfortunately the low rate environment generates incentives and the capacity to postpone necessary reforms and adjustments. The benefits of low rates may decrease after a while and the costs may accumulate. We need to use the time we have left wisely.
Thank you for your time this evening, and for your contributions to the promotion of effective and globally consistent supervision and financial stability.