Including updates on global systemically important insurers and money market funds

 

Stick to the knitting: systemically important insurers

The International Association of Insurance Supervisors (IAIS) is expected to publish the list of systemically important insurers (G-SIIs) this month (although rumours suggest this might be significantly delayed), triggering a range of requirements on G-SIIs including enhanced supervision, capital buffers and the removal of barriers to orderly resolution.

Addressing the moral hazard of too big to fail (TBTF) has been a hot topic since the crisis. Not surprisingly, the initial focus was on banks but Jamie Caruna, General Manager of the Bank for International Settlements, believes we now need to tackle the risks of TBTF in other sectors.

Insurers argued against prosaically applying banking-type reforms to their sector, explaining that the traditional banking model (i.e. deposit gathering, credit intermediation and investment services) is very different from the traditional insurance model (i.e. pooling insurance risk, liability-driven investments, and stable cash outflows over a long horizon). Fundamentally insurers do a better job of matching assets with liabilities, are less exposed than banks to the systemic risk of maturity transformation, and carry substantially lower positions in derivatives. In December, the Geneva Association, an insurance industry think-tank, reported on the differences between both sectors. The report compared 28 global systemically important banks with 28 of the largest insurance firms across a range of indicators. Compared with the average insurer, the study found that the average bank is

  • significantly larger (by a factor of 3.9 times in terms of assets)
  • writes 158 times more gross notional Credit Default Swaps
  • carries 219 times more gross derivative exposure
  • relies on more short-term funding.

While international standard setters accept the differences between both sectors, they still believe that the disorderly failure of an insurer could be as disruptive to the global financial system and economy, and have pushed ahead with rolling out an additional supervisory framework for G-SIIs.

IAIS has been at the fore-front of delineating an insurance-specific solution to the problem of TBTF. In May 2012 it outlined an assessment methodology for identifying G-SIIs. Similar to the Basel Committee’s approach to identifying G-SIBs, the IAIS approach attempts to measure global systemic importance by focusing more on the impact that an insurer’s distress or failure could cause, rather than the probability of such a failure. The assessment methodology is based on three steps: the collection of data, an indicator-based assessment of the data, and a process of supervisory judgment and validation based on an 18-point system. The 18-point system is divided into five categories covering size, global activity, interconnectedness, substitutability, and non-traditional and non-insurance activities. Over and above their size and global reach (5-10% weighting for each), the range and scope of firms’ non-traditional insurance activities (40-50% weighting) and the level of interconnectedness (30-40% weighting) is important when determining G-SIIs status.

The overall weighting structure is markedly different to banks, where size is a much more important factor. IAIS is of the opinion that size in traditionally regulated insurance is actually a favourable characteristic since “in an insurance context size is a prerequisite for effective pooling and diversification of risks" (pg. 19). Insurance is built on the law of large numbers, which holds that the aggregation of a large number of idiosyncratic risks ultimately results in a quasi-normal curve of distribution. Historical data tends to prove that holding a large number of ideally uncorrelated risks from policy holders will result in a well-diversified portfolio. Therefore, the risk profile of an insurer actually becomes less risky as more risks are assumed.

So the majority of the analysis will be based on firms’ non-traditional insurance activities, which includes derivative trading, financial guarantees, non-policyholder liabilities, and short term funding. Life assurers were particularly irked about the inclusion of variable annuities in the list, which account for a significant chunk of their business. Moreover, many other insurers expressed concerns about the entire methodology (a compilation of responses can be viewed here), calling on IAIS to tread carefully in its work. In February, Julian Adams, Director of Insurance at the PRA, outlined that the UK regulator will be also examining the use of leverage, asset transformation and assumptions of credit risk at each firm when taking a decision on systemic importance.

Firms which are designated as G-SIIs will have to manage their risks effectively, in particular liquidity planning and management. IAIS’s proposed requirements for G-SIIs also includes a cascading approach to higher loss absorption capacity. The FT reported last month that any capital surcharge will only be applied to the part of the G-SIIs balance sheet which constitutes non-traditional non-insurance business—a welcome change from the original proposals if proven correct. Finally, G-SIIs, like their banking peers, will have to prepare recovery and resolution plans consistent with the FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions, with some insurance specific modifications. Resolution authorities typically will have more time to resolve/recover a failed insurer (as they not subject to ‘runs’, liabilities are more illiquid), but this is still a difficult process particularly in winding-up cross-border insurance firms. Insurers have some time to adapt to these changes. The higher loss absorption requirements will not kick-in until at least 2019; the other requirements will happen sooner, but are unlikely to affect what insurers to any great degree.

Since insurers can migrate in and out of G-SII status over time, they have incentives to adjust their risk profile and reduce their systemic importance where applicable. But there will definitely be a trade-off, particularly for life insurers, who are scrapping for high yields in the current environment. Some might look towards the non-banking system for this yield; others will stick to the knitting. For further information on the G-SII regime please see our October 2012 hot topic.

 

Wide deviation in supervising MMFs

ESMA published its Peer Review – Money Market Fund (MMF) Guidelines on 15 April 2013. The Peer Review was conducted last summer and looks at how EU Member States implemented CESR’s (ESMA’s predecessor) guidelines on a common definition of MMFs.

The guidelines identified two types of MMF in the EU – short-term money market funds and money market funds - and apply to both UCITS and non-UCITS. Only funds meeting the strict requirements for each type of MMF can call themselves an MMF. All other funds must not market themselves in any way as a MMF. Member States were supposed to implement the guidelines by 1 July 2011.

ESMA’s Peer Review discovers that six Member States have not yet implemented the guidelines, with another four Member States only implementing the guidelines since the Peer Review. Of those Member States that have implemented the guidelines there are some differences between how regulators supervise fund managers and funds to ensure compliance with the guidelines.

In particular, ESMA finds that some regulators pre-approve fund documentation for MMFs, whereas others will carry out ex-post monitoring of documentation. Additionally there are different supervisory approaches: Luxembourg applies specific MMF reporting requirements whereas all other regulators have not developed any specific supervisory practices for monitoring MMFs and their compliance with the guidelines, aside from reviewing annual and semi-annual report and accounts.

ESMA does not just review existing practices. The Peer Review also includes some best practice advice for regulators. ESMA suggests that regulators should have appropriate resources, procedures and organisational structures for monitoring MMFs and detecting any breaches of the guidelines. Further, regulators should be able to demonstrate they possess adequate resources to analyse quantitative data received from MMFs.

When CESR introduced common guidelines for MMFs, these did not include any reference to how supervisors should ensure compliance. However, ESMA is using this Peer Review as an opportunity to seek greater supervisory convergence across the EU, which is part of its remit.

MMFs are commonly considered to be a key part of the global discussions around “shadow banking". Many in Europe argue against this view noting that we already have a strong regulatory and supervisory approach to MMFs through the UCITS legislation and AIFMD which will be applied later this year. Therefore ESMA’s Peer Review should be welcomed; if regulators are able to act upon the suggested best practice it will strengthen the view that MMFs in Europe should be left out of this debate.

 

Clouds still hang over the EU financial system

You do not need to look much further than the first line of the European Supervisory Authorities (ESA) new risk and vulnerabilities report to get a feel for the challenges facing EU policy markers: “the European financial system continues to face a daunting range of interrelated risks." Paraphrasing the next few lines, the report indicates that things have improved a little in recent months (thanks in part to (unsustainable) Central Bank interventions), but significant vulnerabilities to cross-sector stability persist.

The weak macroeconomic environment is a significant drag on EU financial institutions. It impacts the financial positions of governments, private and commercial borrowers (i.e. their customers and assets) and the outlook for property markets (i.e. collateral), and may lead to further deterioration in the profitability and asset quality of banks, insurers and other financial market participants. Investors (and regulators of late) remain concerned about the balance sheet valuation and risk disclosures of financial institutions. Investors value the equity of many EU financial institutions at a significant discount to their book values.

New risks have come to light recently. Commentators, including the ESAs, are talking about the various negative side effects from the low interest rate environment on the financial system, which includes:

  • solvency pressures on insurers and defined-benefit pension funds from higher present value of long-term liabilities and depressed reinvestment returns
  • incentives for search for yield behaviour by institutional investors
  • profitability pressures on bank net interest margins
  • risk of hidden forbearance.

The report also talks about the risks of further fragmentation of the EU Single Market. Many banks in Western Europe have retrenched to their home markets since the crisis (despite the Vienna initiative). This trend has been driven mainly by financial institutions’ revised business strategies (e.g. focus on core businesses), changes in risk appetite, higher funding costs and the challenging macroeconomic environment.

Finally the ESAs report that confidence in financial markets is still impaired. The misconduct in banks’ submissions to the formulation of financial benchmarks which came to light last year is one of a number of episodes that has shaken investors’ trust in financial markets. The ESAs suggest a “concerted effort" is needed to correct this.