Following the financial crisis, attention is inevitably turning to the issue of designing regulatory frameworks that will prevent a re-occurrence of this crisis. The question for regulators is whether the insurance and reinsurance industries are a source of systemic risk.

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 recently published report, Systemic Risk in Insurance by the Geneva Association, argues that the non-life re/insurance industry is not a source of systemic risk; it can only be a transmitter of risk. The resilience of the re/insurance industry in the aftermath of the recent financial crisis supports this. With the exception of those companies that provided financial guarantee or used practices more akin to banking, our industry emerged in excellent shape without any government bailouts.

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• A reinsurance company is a “closed-end” fund, where funds cannot be withdrawn by clients or capital providers/funders in an accelerated fashion.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.
• The industry's concept of risk management is much more robust and our risk measurement tools are more sophisticated than those of the banks.
• Portfolios are much better diversified with uncorrelated risks, unlike banks.
• 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, reinsurance is a fragmented industry which means that we can withstand the loss of any one participant in the industry and that capacity, on a global basis, will continue to be available so that risk can be transferred on a continuous basis.

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 designed to address a “financial conglomerate” when there is none, seems inefficient and ineffective.

Worse, unchecked regulation could make reinsurance a greater risk to the economic system than it is now. An over-reliance by regulators on models instead of capital and limits would increase the “tail” risk in the industry. 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.

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; however supervision should be informed by the unique economics of our business. First, regulation should be focused on our “promise to pay” i.e. solvency, not return. 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 optimization 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 their place on the risk/return spectrum.

What we would like to see is a regulatory regime that is intelligent, has a light touch in all matters except solvency and that acknowledges the fundamental strength and resilience of the non-life re/insurance model. It is up to us all to make that case.

The full version of this article appears in the CEO Risk Forum published by Reactions