Reactions: CEO Forum–Thiele calls for balanced regulation

Reactions published this article on April 28, 2010.

The (re)insurance industry does not contribute to systemic risk in the financial markets, says PartnerRe CEO Patrick Thiele, and supervisors should take that into account in their plans.

As the world recovers from its brush with financial collapse and depression, attention inevitably turns to the issue of designing regulatory frameworks that will prevent a re-occurrence of this crisis. As part of that exercise, economists, politicians and regulators are examining the concept of systemic risk: what is it, does it truly exist, what form could it take, which industries and companies may be its source, how could it be transmitted to other sectors and what should be done about it. These are extremely important questions and deserve a broad and open discussion before irrevocable decisions are made. This article is PartnerRe’s attempt to contribute to that debate from a reinsurer’s perspective.

Systemic risk can be defined in many ways but in this context, it is the risk that the failure of one or several financial entities damages the whole system, with major consequences to the economy (crisis, depression, unemployment).

The recent Geneva Association’s Systemic Risk in Insurance report demonstrated that the non-life re/insurance industry is not a source of systemic risk but can only be a transmitter of risk. This was recently evidenced by the resilience of the industry in withstanding the financial crisis. With the exception of those companies that provided financial guarantee or used practices more akin to banking, there were no casualties and the industry emerged in excellent shape and ready to meet society’s risk transfer needs without any help from governments.

The attributes of the non-life re/insurance business model that make it financial crisis-resistant are well-known and basically irrefutable:

• A reinsurance company is a “closed-end” fund, where funds cannot be withdrawn by clients or capital providers/funders in an accelerated fashion. That means that we bear very little liquidity risk compared to banks and hedge funds;
• Non-life reinsurers operate at very low levels of leverage. Typically we carry capital equivalent to 15% to 30% of our assets, at least double that of banks. This means we can withstand shock losses (1 in 50 or 100 year events) without damage to our claims paying capabilities;
• Our concept of risk management is much more robust and our risk measurement tools are more sophisticated than those of the banks. We do not exclude the “risky stuff” when calculating our volatility (or VAR);
• Our portfolios are much better diversified with uncorrelated risks, unlike banks;
• Our major, non-capital markets risks are either capped at a percentage of capital (natural catastrophe) or manifested over an extended period of time (mass tort) obviating a capital or liquidity crisis;
• Unlike the banking industry which is dominated by “too big to fail” firms, reinsurance is a fragmented industry which means that we can withstand the loss of any one participant in the industry and that, on a global basis, capacity will continue to be available so that risk can be transferred on a continuous basis.

This last point is important in that while there are some mixed insurance/reinsurance groups, there are no “financial conglomerates” left in the global non-life re/insurance industry of the size of AIG. To put in place regulation that is designed to address a “financial conglomerate” when there are none, seems inefficient and ineffective.

Having said all this, it is important to note that unchecked regulation has the potential to make reinsurance a greater risk to the economic system than it is now.

First, regulators seem to be moving towards a reliance on risk models in their evaluation of the industry’s solvency, despite the obvious recent failures of the models of the rating agencies and banks. Over-reliance on models instead of capital and limits would increase the “tail” risk in the industry.

Second, convergence of the capital and reinsurance markets, if not properly regulated, could have significant negative consequences. There is the potential for the mis-selling of risk when equity-type risks are packaged as fixed income securities and sold to unsophisticated investors. Convergence is also likely to lead to increased use of collateralisation which will paradoxically increase risk to the cedant by introducing liquidity risk to the reinsurer.

So what is the role of the regulator in the non-life re/insurance industry? We strongly believe the industry needs to be effectively regulated. We don’t advocate a laissez-faire approach to our industry. It is too important economically and socially to operate without any governmental supervision. However, we do think that supervision should be informed by the unique economics of our business.

Regulation should be focused on our “promise to pay” i.e. solvency, not return. For example, the dominance of GAAP (income statement) accounting over statutory (balance sheet) accounting is reflective of an imbalance towards shareholder interests. A better balance needs to be established by the regulator so that managements are not forced to choose between shareholders’ and clients’ best interests but to encourage optimisation of the two.

Finally, regulators should not legislate one risk appetite for the industry. Non-life insurers and reinsurers must be allowed to function within a wide range of risk/return strategies and regulators need to allow companies to determine where on the risk/return spectrum they want to be, and manage their company accordingly, finding the right balance between risk and return.

We believe that if the facts and reasoning are presented to governments and regulators, the right form of regulation will come about: a regulatory regime that is intelligent, has a light touch in all matters except solvency and one that acknowledges the fundamental strength and resilience of the non-life re/insurance model. It is up to the industry to make that case.