IAIS release initial analysis of systemic risk and the insurance sector

Specifically in conjunction with a lack of substitutability in a non-competitive market, the potential failure of a significant insurance company could conceivably create significant disruption to households and businesses in terms of shortage of insurance capacity. This might occur, for example, if a type of insurance cover that is crucial to conduct specific businesses in the real economy became unavailable. On the other hand, an extremely competitive insurance market with low premiums or weak underwriting practices may weaken the resilience of the insurance market in the event of financial or economic shocks.

The importance of underwriting has been highlighted by financial guarantee companies recently, and the importance of such financial guarantee companies with respect to the wider financial system has become quite obvious in the recent past. Financial guarantee companies provide significant protection extended to other financial institutions such as banks. In underwriting and pricing of risks, some of these insurers have not fully appreciated the possibility of systemic risk and underlying correlations of risks.

As a result, these insurers came under pressure and other financial institutions were affected in two ways. Their ability to raise funds from the market was restricted due to reduced liquidity generally. They also had to restrict the credit they made available to the real economy because credit enhancement was no longer as readily available. It is important to recognise that stress in the real economy or financial system caused by factors outside the insurance sector has been shown most likely to trigger the stress or failure of these types of insurers.

Trade credit insurance provides an example of insurance capacity reduction. If trade credit insurers withdraw from the market, as some did in the current crisis, then that can have a direct impact on the ability of the real economy to engage in international trade. In the current crisis, some governments needed to provide guarantees to ensure trade credit insurers either did not fail and/or continued to provide their product so that trade could continue.



Another example of shortage of insurance cover is the terror attack in New York on September 11, 2001 and the sharp reduction of aviation insurance cover and property reinsurance cover thereafter, due to the reassessment of the risk of such cover.

As a result, systemic risk with a bearing on financial stability and the real economy posed by the insurance sector is of a different nature because of the insurance business model. In the insurance sector the time horizon plays a relevant role, for systemic problems tend to emerge over a longer time horizon than for banking. While banking failures may arise in a matter of hours or days, insurance failures usually take months or years, although loss of insurance capacity could emerge in weeks, if insurers or reinsurers cease offering cover after serious problems are discovered.

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