Systemic risk, however, can also materialise in other parts of the financial industry – both in the insurance sector and in the non-bank non-insurance (NBNI) sector . In an essay for the recently published book “The Economics, Regulation, and Systemic Risk of Insurance Markets”, BaFin President Felix Hufeld describes how, from his point of view, the insurance industry should deal with these risks.

Hybrid approach

To appropriately address systemic risk in the insurance industry, Hufeld explains, a “hybrid approach” will have to be applied – unlike in the banking sector, where systemic risk can be captured appropriately by focusing on individual banks or banking groups. A hybrid approach considers the need to develop and combine two conceptually different regulatory frameworks in order to comprehensively manage the systemic risk that may emerge within or through the insurance sector. The decisive element, Hufeld writes, is the distinction between direct and indirect systemic risk. In order to appropriately monitor both types of systemic risk, specific regulatory responses and supervisory measures have to be identified for each of them.

According to Hufeld, direct systemic risk refers to the potential consequences for the financial system which may be caused by a single insurer or insurance group, with the causes of this detrimental impact lying immediately in the nature, activities, product features etc. of the insurer itself. In combination with its size and degree of interconnectedness, this could directly create disturbances of systemic proportions in the financial system.

Indirect systemic risk is defined by Hufeld as the potential negative consequences for the financial system due to the activities of one or many insurers or insurance groups when these react (collectively) to negative events or shocks to which they themselves have been exposed to.

Direct systemic risk

Whether systemic risk is inherent in an insurer or not is decided based on a designation methodology developed by the International Association of Insurance Supervisors (IAIS). On the basis of this methodology, nine insurance groups are currently designated as global systemically important insurers (G-SIIs) – far fewer than in the banking sector. The three main categories of supervisory measures are enhanced supervision, in particular at the group level, precautionary definition of recovery and resolution plans as well as capital add-ons to establish a higher loss absorbency capacity.

In his essay, Hufeld also addresses the criticism voiced regarding the concept of G-SIIs. One of the objections raised frequently is that there is no systemic risk inherent in the insurance business model and in the insurance industry as a whole. With respect to direct systemic risk, Hufeld agrees with the IAIS's point of view: the potential for systemic importance is only considered to arise in any non-traditional or non-insurance activities. In principle, however, complex, internationally active insurance groups (IAIGs) can also have NTNI activities as part of their business portfolio. Therefore, the G-SII designation methodology will have to be further refined in order to improve its capability to capture and mitigate systemic risk and disincentivise the taking of such risk.

In his essay, Hufeld also elaborates on the issue raised by critics of whether capital add-ons to establish higher loss absorbency are the right remedy. According to the BaFin President, some of the criticism is justified. This, however, does not make the regulatory goal (to internalize externalities) obsolete. Conceptually, there is no reason not to apply an HLA concept in the insurance industry. It would be necessary, however, to calibrate the capital add-on properly and to fine-tune the G-SII methodology in general. This is also the goal pursued by the IAIS.

Indirect systemic risk

Examples of indirect systemic risk mentioned by Hufeld are the sudden devaluation of certain sovereign bonds, the default of one large issuer of covered bonds, a sudden and massive break-down of equity markets, or a prolonged period of very low interest rates, possibly followed by a sudden spike in interest rates. Therefore, indirect systemic risk involves risks which, although generally triggered by exposure to external shocks or events, only become “systemic” due to their impact on multiple insurers and their possible collective reactions to them. The number of insurers affected is almost impossible to determine in advance. The potential for systemic risk, Hufeld explains, exists even with medium-sized or small insurers which would never be considered “systemic” individually.

The second component of the hybrid approach is therefore not corporate- but rather “activity- or market-centric” and explicitly deals with safeguards focusing on collective behaviour. According to Hufeld, this is the domain of the respective general regulatory framework, such as the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG), the Solvency II Directive in Europe and, globally, the Insurance Core Principles (ICPs) of the IAIS, ComFrame for internationally active insurance groups (IAIGs) and the global insurance capital standard, ICS, currently being developed by the IAIS.

According to Hufeld, however, general insurance regulation traditionally focuses more on policyholder protection and less so on matters of financial stability. Therefore, a consistent and explicit framework for effectively managing indirect systemic risk based on collective behaviour needs to be developed. Such a framework may include, but is not identical with, what is commonly called a “macroprudential” perspective. Which combination of strategies and tools works best in order to formulate new regulatory and supervisory responses to tackle systemic risk needs to be determined through further work, he went on to say.