IAIS release initial analysis of systemic risk and the insurance sector

Based on the very wide working definition of systemic risk used by the IMF/FSB/BIS and because of the integral role that insurance plays in the economy, it has to be examined whether and under what circumstances insurance activities or insurers may generate or amplify systemic risk.

Systemic risk may arise in the insurance sector when insurance market capacity declines or disappears. It could be caused by, for example, the failure of one or more insurers or by the withdrawal of insurance or reinsurance cover (as has occurred, for example, with terrorism cover). In most cases, quick substitution is observed through new capacity becoming available (e.g. catastrophe insurance) but there can also be situations where that does not occur.

Insurers are also subject to direct counterparty risk that could cause the failure of related financial institutions by way of immediate contagion effects. If an insurer, an insurance group or a conglomerate is engaged in activities directly related to banking, capital markets or other financial business (e.g. financial guarantee activities), it is more likely to pose systemic risk of an immediate nature. However, an insurer is more likely to be the recipient or the amplifier of systemic risk of an immediate nature emanating from other economic agents rather than being the source of such risk.

As the insurance sector is typically among the largest investors, a sudden decrease in the value of investments or movements of interest rates may adversely affect the portfolio of an insurance company and its liquidity. A severe decline in asset prices may even lead to fire sales of assets and affect the entire market, especially if policyholders lose confidence and seek to surrender their policies in large numbers.

Withdrawal from purchasing financial instruments issued by banks may further lead to a contraction of credit products available in the real economy. Hence, in the area of investment activity, the insurance industry can act as an amplifier of systemic risk.





These different potential sources of risk could emerge individually but could also be combined and therefore compound a systemic problem.

Returning to the issue of capacity reduction, there are several reasons why an insurer might fail or cease to provide capacity for some classes of business. One important source of an insurance failure or malfunction is related to core insurance functions of underwriting and provisioning. Underwriting risk arises when insured risks are misjudged or mis-estimated. Hence, technical provisions and related assets will be assessed as inadequate eventually.

A further source of an insurance failure could be via reinsurance exposure. A sudden failure of a reinsurer may cause direct insurers to lose protection for lines of direct insurance and thus come under financial stress.

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