Karen Petrou Remarks – Insurance In The Systemic Cross-Hairs: Workable, Realistic Regulation and Resolution for the New Age

It is an honor to speak again to NOLHGA’s annual meeting and to such an influential group of insurance-industry regulators and executives. You gather at a critical time when your expertise – orderly resolution of a faltering insurance company – is urgently needed by both U.S. and global policy-makers. Led by Peter Gallanis, I know you are at the forefront of this vital debate. I’d like this afternoon to put it in the broad framework of how policy-makers are assessing systemic risk both in insurance and other financial institutions to bridge a bit of the communications gap that has so far stymied efforts at a forward-looking, systemic risk-ready resolution solution.

You’re right – the current systemic framework is bank-centric, meaning that much of it doesn’t fit easily – if at all – with how insurance companies operate. However, policy-makers are also right – if there’s no clear, reliable way to ensure recovery and resolution for complex, cross-border, and non-traditional insurance companies, then all the insurance-suitable regulations are for naught. Indeed, they may even be counter-productive, because risk will simply move from big banks to big insurance companies. If only to cut this off, regulators believe they must govern insurance companies and, if they can’t quickly find an insurance-ready solution, then they’ll use the rules close at hand. Bank-centric rules could actually make some insurance companies riskier, but you will understand why policy-makers go to the rules they know to combat the risks they fear.

What I’d like to do in my remaining time is lay out some of the challenges I see and further actions you all could take to bridge the insurance/bank divide. I’ll do so by first describing the risks I think insurance companies pose to financial stability, some of these resulting from growing longevity risk in the sector, some from non-traditional activities, some because of governmental edicts, and some from what happens to big financial companies when big financial markets go bad. I’ll then lay out why I think what you do – resolution – is the most important way to address each of these risks.

Prudential rules protect insurance companies from themselves and make them more resilient to external shock. But, at the end of the day, what we need for market discipline and financial stability are firms that, if they take undue risk, immolate without causing conflagrations for policy-holders and the broader financial system – an end to too-big-to-fail is just as critical for insurance companies as it is for the very biggest banks.

Systemic-Risk Drivers

I think it’s important first to recognize what U.S. insurance regulation does well and what it yet has well to address. Regulation has many goals – in insurance, these include ensuring appropriate business conduct and claims-paying capacity under normal market conditions. Post-crisis rules are beginning to address stress scenarios, but divisions among the states, opposition from the industry, and genuine disagreement about what happens to whom how in severely-adverse scenarios has slowed much of this work to a scary crawl. Risk, though, is racing ahead.

What scares me? Time doesn’t permit a detailed description of each insurance-sector risk with potentially systemic ramifications, but let me describe a few that worry me and, more importantly, global policy-makers and U.S. regulators:

  • Yield-Chasing: You all know that life-insurance companies must pay out claims over extended periods of time based on actuarial risk. As a result, claims-paying risk is not meaningfully affected by macroeconomic or financial-stability considerations – at least it isn’t when these stresses come in short spurts and the insurance company’s risk profile isn’t heightened by other exposures. But, when external conditions create prolonged periods of ultra-low or, now, even negative real rates, the ability of insurance companies to earn enough prudently to ensure long-term, claims-paying capacity is seriously undermined. Higher-yielding assets pose all sorts of higher risks, risks not well addressed by insurance regulations such as concentration, correlation, “cliff-effect,” or interest-rate risk. As a result, even if companies can weather prolonged low rates and over time meet claims, they could at any point between now and market normalization be subject to significant risks based on how long it takes them to rebalance their portfolios and what happens in the meantime.
  • Intra-Group Risk: Although most U.S. life-and health-insurance companies are far less complex than global systemically-important banks (G-SIBs), some companies engage in a wide array of activities across product segments, financial sectors, and national jurisdictions. Insurance companies are not generally subject to inter-affiliate transaction limits that protect insurance claims-paying capacity, nor are there usually limits on upstreaming dividends from insurance companies to the top-tier parent. Under earnings stress or risk at an affiliate (e.g., a captive re), the insurance subsidiary could become severely strained.
  • Operational risk. This is a major concern of bank regulators, and it’s just as critical for insurance companies in this day of cyber-security risk. Recovery and contingency-funding plans are critical to operational-risk resilience, but companies can’t always be counted upon to lay in redundant systems, back-up liquidity, and other buffers if rules don’t mandate this.
  • Non-Traditional Activities: You are well aware of ongoing work at the International Association of Insurance Supervisors (IAIS) to categorize non-traditional activities at large insurance companies. Securities lending is one to which I draw your attention. It is becoming an increasingly significant activity to support yield, but it creates balance-sheet risk for which insurance-company capital regulation is ill-designed. G-SIBs are under tough new rules affecting capital and liquidity requirements constraining their secfin operations, leading more of it to migrate to large insurance companies. This is a low-margin, low-risk business under normal circumstances, but risks can change fast under stress and it’s not at all clear that large insurance companies are well insulated from it. The same holds true for insurance-company banking and asset-management activities.
  • Policy Risk: Let me finally quickly mention one risk I think particularly acute for U.S. insurance companies. You all know this all too well – health insurance is now dictated in form, content, and price by federal and state regulation. This may well be warranted for fairness and even humanitarian reasons, but it changes the underlying business proposition. A wave of consolidation has swept the sector to squeeze out inefficiencies and sustain earnings. History teaches us that not all of these deals will go well and that resulting companies could pose even greater prudential and resolution challenges. The merged company might not be systemic in the near term because health-company risks are less significant in the areas I briefly noted. They could, though, grow in tandem with earnings pressure, especially if ultra-low rates continue. Health insurance is an urgent national service and its absence poses another serious systemic risk akin to the loss of critical market infrastructure like payment, settlement, and clearing.

Resolving Systemic Risk with Orderly Resolution

I hope recognition of these all-too-real risks leads to real prudential solutions, but effective orderly resolution is our safety valve. If rules don’t work, then markets and policy-holders will still be protected if, when an insurance company fails, no one beyond management, creditors, or shareholders gets badly hurt.

As with insured bank depositors, policy-holders protected by your guaranty associations are the top of the claims-priority order – hence the

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