Regulation and supervision in insurance and banking: Greater convergence, shared challenges
Speech by Malcolm D Knight, General Manager of the BIS, at the IAIS 11th Annual Conference in Amman, Jordan, 6 October 2004.
I am delighted to be here today at this annual conference that brings together insurance supervisors and industry participants from all over the globe. The fact that this is already the 11th event in the series and that it is taking place here in Jordan is testimony to the long road that insurance supervisors have already travelled from the days not so many years ago, when international cooperation in this area was just beginning to take shape.
At the Bank for International Settlements we feel honoured and privileged to be able to make our small contribution to this journey, by hosting the Secretariat of the IAIS at our headquarters in Basel since 1998. For me personally, it is truly a rewarding experience to see from close up the cooperative efforts of standard setters in different realms of the financial system - banking, insurance, payment systems, and those concerned with "macroprudential" issues - as they strengthen and broaden their collaboration.
In my remarks today I would like to put these major efforts to develop more effective supervisory standards for insurance providers into the broader context of the never-ending evolution of the global financial industry at large. In particular, I would like to explore with you the implications for the framework of prudential regulation and supervision of the historically unprecedented process of convergence that has been shaping the financial industry. What I have in mind is convergence along three dimensions: first, between financial institutions and capital markets; second, among different types of financial institutions; and, third, among different national jurisdictions. In doing so - as I did a couple of weeks ago at the International Conference of Banking Supervisors in Madrid - I would like to highlight the similarities in the efforts of insurance and banking supervisors and how their paths have inevitably come to meet.
My exploration will consist of two parts. In the first part, I will look at how the convergence process has influenced the parallel policy responses of banking supervisors and insurance supervisors respectively, and stress the inexorably growing area of shared concerns. Then, in the second part of my talk, I will examine in more detail one common challenge - itself the offspring of the convergence process - that, in my view, will loom large in the years ahead. This is the question of how to ensure that accounting standards and prudential frameworks are mutually consistent.
My key message today is that the challenges posed by convergence highlight the importance of cross-fertilisation of different perspectives. In particular, there is much that banking supervisors and insurance authorities can mutually learn from each other. And this dialogue should be embedded in a broader one encompassing other groupings too, not least accounting standard setters, so as to reach a common understanding of the problems facing policymakers and a common solution to them.
I. Greater convergence
The process of convergence that has been shaping the global financial industry over the past two decades has been powerful and broadly based. The drivers of this convergence are such phenomena as financial liberalisation, technological advances in elaborating and disseminating information, and breakthroughs in risk management and in pricing complex financial instruments. These inexorable forces of convergence have made themselves felt across financial institutions and markets, across different types of financial institution and across national jurisdictions.
First, the respective roles of capital markets and of financial institutions have been converging. Markets have made major inroads as mechanisms for allocating both funds and risks within the economy that were once primarily the domain of banking institutions or other regulated financial intermediaries. By now markets are not only a key supplier of credit but also a provider of traditional insurance services. Think, for instance, of the rapid growth of catastrophy bonds. In addition, they transfer risks across segments of the financial system, not least through derivatives. Initially, derivatives addressed market risk; now, the unfolding revolution is in instruments to manage credit risk. Crucially, in the process, the dividing line between market-traded and non-traded financial instruments and that between insurance and other types of financial instruments that provide protection from specific risks have become increasingly blurred. Credit risk insurance can, in fact, be thought of as one such example.
Second, different types of financial institutions have been converging. This has been true even as the financial landscape has become more diverse. In insurance, for instance, companies have been providing products with an increasing financial component. Thus, through products such as single premium unit-linked insurance policies, insurance providers now compete directly with mutual funds. And the growth of conglomerates that encompass both insurance and banking has eroded the long-standing barriers that had kept these two lines of business apart.
Third, financial arrangements across different national jurisdictions have been converging - a process that most of us know as "financial globalisation". As obstacles to capital flows, foreign establishment and the cross-border provision of financial services have come down, the pressure to adopt similar arrangements across countries has grown. In insurance, for instance, cross-border ownership of companies has increased considerably.
These powerful forces of convergence have been mirrored in developments in risk management. With risk management evolving from a side constraint on financial activity to a core function underpinning that activity, the similarities between the risks faced by different institutions have become increasingly apparent. In the process, the "language" barriers that used to separate the analysis of risks in different lines of business as well as in strands of academic thinking have slowly been breaking down. For example, a moment's reflection is sufficient to realise that value-at-risk measures that are common in banking and the stochastic asset-liability techniques that are common in insurance are, conceptually, the same sort of tool; they differ primarily with respect to the instruments included in the analysis and the horizon used for assessing risk.
This recognition has gone hand in hand with efforts to move towards a more integrated firm-wide approach to financial risk management. Across business lines, this means managing the same risk in the same way regardless of its location in an enterprise. Across different types of risk, it means developing a common metric for the aggregation of risks and for the calibration of economic capital. Clearly, even cutting-edge enterprises are a long way from fully achieving either objective. The aggregation of risks in conglomerates spanning banking and insurance is very much in its infancy. The broad direction, however, is unmistakable.
The same convergence forces have also resulted in greater convergence in prudential frameworks. This has been the case along different dimensions.
The first dimension is across national jurisdictions. It has become increasingly difficult to pursue purely country-specific solutions. Hence the search for internationally agreed common prudential standards. The process, spearheaded by the Basel Committee on Banking Supervision, was then extended to securities regulators and, later in the 1990s, to insurance supervisors. As a result, in insurance the process has not gone as far. Obviously, the very diverse initial conditions have complicated progress. And the less international nature of much of the insurance business has until recently limited the incentives towards greater convergence. For example, except in Europe, unlike in banking there is as yet no agreed set of capital adequacy and solvency standards for insurance companies. Even so, as the experience in banking shows, I have no doubt that, with time, similar progress will be made in insurance too.
The second dimension of convergence in prudential frameworks is across functional lines. The differences in approach have narrowed. Just as in banking, a set of core principles now lays out the broad prudential framework in insurance too. And by now capital adequacy, supervisory review of risk management processes, and enhanced public disclosures are all emerging as common elements in both sectors. Importantly, prudential arrangements are increasingly seeking to work with, as opposed to against, the grain of market forces and to be aligned with best practices in risk management. The trend towards convergence has also been strengthened by the establishment of "integrated supervisors" in over 30 countries and, internationally, by the creation of the Joint Forum. The Forum has been performing a valuable role in identifying differences in prudential arrangements across sectors and in considering the ever larger set of issues of common interest across the different supervisory communities. Think, for instance, of the exercise under way aimed at mapping similarities and differences in regulatory practices across sectors with a view to considering their implications for the effective supervision of conglomerates.
Third is system-wide convergence. Both insurance supervisors and banking supervisors are becoming increasingly aware of the need to address risks also on a system-wide, sometimes referred to as "macroprudential", basis. Convergence and the greater ease with which risks can now be shifted across sectors, not least to exploit regulatory differences, have put a premium on this type of analysis, which focuses on systemic vulnerabilities. An obvious example of this new focus is the set of studies done on the impact of credit risk transfer instruments on the allocation of credit risk across the financial system, including work by the Joint Forum. Another example is the IAIS work under way aimed at improving transparency in the reinsurance sector - a sector which, owing to its potential concentration of risks and its strategic role, can be of major significance for systemic stability and is still largely unsupervised in some countries. More generally, participation of the IAIS in the Financial Stability Forum alongside other international regulators, international financial institutions, central banks and finance ministries has allowed them to take an active part in regular macroprudential assessments of the global financial system.
These trends call for closer cooperation between insurance supervisors and banking supervisors. Cooperation is needed to produce standards that are mutually consistent, thereby limiting the scope of regulatory arbitrage and helping to promote a level playing field. It is needed to ensure that conglomerates are adequately supervised, through appropriate exchanges of information. And it is needed to reach a better understanding of potential spillover effects in the financial system.
Indeed, I have often been struck by how much prudential authorities in insurance and banking can learn from each other, once the unfamiliarity with their respective approaches is overcome. Let me illustrate. Insurance supervisors have learned to focus on the risks to financial soundness that arise from the asset side of balance sheets, as opposed to focusing exclusively on the underwriting risks associated with insurance liabilities. For their part, banking supervisors are beginning to pay more attention to the adequacy of pricing policies in covering expected losses - which is a long-standing practice in insurance. I think that this is an area that will require much more attention in future. The general message is that cross-fertilisation between the two communities of standard setters should be encouraged.
II. The financial reporting challenge
Against the background of these powerful convergence forces, it is not surprising if the challenges faced by the banking and insurance supervisory communities are increasingly shared ones and affect all aspects of their activities. The emerging financial reporting challenge is an excellent illustration of this point. Let me explain.
Global financial markets - the epitome of forces towards convergence - naturally go hand in hand with global financial reporting practices. This is the rationale for the intense efforts that are under way to establish a common set of internationally accepted financial reporting standards (IFRS). There is now a broad consensus over their importance for the proper functioning and stability of the financial system. Alongside core principles for prudential frameworks in banking and insurance, accounting standards have been included among the 12 standards identified by the Financial Stability Forum as conducive to a robust financial infrastructure.
But it is one thing to agree on the importance of common financial reporting standards, and quite another to agree on a specific set. The development of international financial reporting standards has brought to the fore important differences in perspective between accounting standard setters on the one hand, and prudential authorities on the other, that will need to be reconciled. The stakes are high.
Why such differences in perspective? I would trace them largely to differences in objectives. Accounting authorities have increasingly been seeking to establish "unbiased", or so-called "true and fair", pictures of the financial condition of firms. This has meant departing somewhat from a time-honoured accounting tradition that had leaned more towards conservative assessments of a firm's financial condition. By contrast, financial supervisory authorities, be it in insurance or banking, seek to instil prudent behaviour in the firms they supervise. As a result, they are more naturally inclined to favour prudent, in the sense of conservative, valuations, often because these are seen as providing helpful safety cushions. In insurance, for instance, some prudential authorities would like accounting standards to recognise forward-looking reserves that have been set aside for catastrophic risks that have not yet materialised - a debate that closely mirrors the attempt by banking supervisors to seek more forward-looking provisions for loans.
What, then, about the way forward? Here, I think it is useful to distinguish between the long-run goal, on the one hand, and the transition towards it, on the other.
As regards the long-run goal, it seems natural for accounting to seek to portray the best approximation to an "unbiased" and comprehensive picture of the financial condition of the firm, while prudential regulation seeks to instil the desired degree of prudence in its behaviour on the basis of that portrayal. Ideally, this would call for a unique set of valuations rather than one for accounting and another for prudential purposes. And it would mean avoiding reliance on deliberately conservative estimates of value as a means of establishing safety cushions. This would have the benefit of greater transparency, of avoiding the risk of unwittingly undermining either of the two objectives, and of facilitating convergence in accounting standards across both sectors and countries.
As regards the movement towards this long-run goal, it is essential that at all stages of the transition, the prudential authorities remain in a position to redress any adverse implications that the needed changes in accounting standards may have for the safety and soundness of regulated financial intermediaries. In other words, the transition should be properly coordinated. For example, to the extent that an uneven recognition of fair value principles across asset categories might introduce artificial volatility in the accounts, prudential authorities should be in a position to counteract its impact on financial stability. I know that insurance supervisors are particularly concerned about this issue, given that the shift to valuing assets at market prices is likely to start well before a common standard for valuation of liabilities is agreed and implemented. But similar issues also arise in banking.
Having said this, it is important to recognise two additional points about the final framework and the process towards it.
First, the portrayal of the financial condition of the firm should cover not just its profitability, cash flows and balance sheet, as it does today, but also its risk profile. This is an area where prudential authorities have taken the lead, by encouraging greater risk disclosure by regulated firms. I would strongly encourage insurance supervisors to strengthen the efforts under way in this area, just as bank supervisors have been doing. The scope for cross-fertilisation should not be underestimated: witness the recent report on risk disclosures carried out under the umbrella of the Joint Forum. Fortunately, the need for disclosure of risk information is beginning to be recognised by the accounting standard setters too: the IASB has launched a project in this area. Prudential standard setters are ideally placed to make major contributions to the development of such risk disclosure standards.
Second, the contribution that prudential authorities can make to the development of accounting standards goes well beyond providing more information on the risk profile of firms. We have all come to recognise that valuations and risk assessments are inextricably intertwined. Since economic agents care deeply about risk, the way current and prospective income streams are valued inevitably incorporates perceptions of risk as well as attitudes towards risk - commonly known as "risk appetite". It follows that prudential authorities can also bring precious value added to the rules for the compilation of traditional accounting information, not least by helping to measure accurately the risk premia used in establishing valuations. Consistency between risk management practices and valuation is essential.
I am optimistic that, over time, we will make progress in the direction I have just outlined. This would call for a further strengthening of the growing dialogue between prudential authorities and accounting standard setters, ideally through tighter institutional arrangements. I am convinced that this dialogue would foster greater convergence of views rooted in a "common language".
To conclude, let me just reiterate the key message. The process of convergence within the global financial system across markets, across institutions and across national jurisdictions puts a premium on a shared understanding of problems and on a shared formulation and implementation of solutions. For insurance supervisors, this implies the need for greater cooperation across national jurisdictions and with other key actors in the policymaking community, particularly with banking supervisors and accounting standard setters. While much has been accomplished in recent years, there is clearly scope to intensify and broaden this dialogue further.
At the Bank for International Settlements, we are very pleased to be able to support the insurance sector in this process, by hosting the IAIS Secretariat and providing strong support to its development. We believe - and I hope you believe too - that the physical proximity of the IAIS Secretariat to the secretariats of the Basel Committee and the Financial Stability Forum as well as with representatives of the central banking community is highly valuable in fostering a better understanding of the different perspectives, in developing a shared and richer view of the policy challenges, and in identifying potential solutions. Looking forward, we at the BIS are steadfast in our commitment to continue to support this dialogue and to see it grow as part of the broader progress towards a safer and sounder financial system.