Speech

The Insurance Industry, Fair Value Accounting and Systemic Financial Stability, Gerd Häusler, Counsellor and Director, International Capital Markets Department, IMF

June 13, 2003

I would like to touch on three subjects:

First, I want to argue that the increasing blurring of the boundaries between insurance and other financial institutions, especially in the OTC derivatives markets, implies a heightened importance of the insurance industry for systemic financial stability and calls for a stronger supervisory focus on financial risks (as opposed to underwriting risks). More disclosure and transparency of financial risks and how they are managed is also becoming increasingly necessary.

Second, I want to highlight that fair value accounting, if properly implemented, will likely make more explicit the redistribution of risks over time that is being done buy insurers almost as a by-product of their core business of risk pooling, and could improve the pricing of those risks.

Third, as the positions in the vigorous debate on fair value accounting appear rather entrenched, I will try to sketch some scope for a middle ground: methods that might address some of the problems associated with fair value accounting while retaining most of the benefits, particularly improved transparency and consistency of financial statements.

I. Systemic Financial Stability

Let me start with the role of the insurance industry for systemic financial stability.

Traditionally primarily banks have been associated with systemic financial stability due to:

· their maturity transformation; and
· their central role in the payment system.

By contrast, financial problems in the insurance industry were viewed as unlikely to become systemic, in part because insurance companies in financial difficulties would face only "slow-moving" liquidity shocks in light of their relatively long-term liabilities. It was therefore considered unlikely that insurers under financial strain having to raise liquidity would have to resort to large-scale rapid asset sales.

But as the dividing lines between banks and insurance companies have become blurred, and as insurers intensified their financial market activities and built up considerable counterparty relationships with banks, the insurance industry has become increasingly relevant for systemic stability.

From the perspective of financial stability, the activities of insurance companies can be viewed from three perspectives:

· the insurance industry as a major source of long-term capital;
· the consolidation between banking and insurance (bancassurance); and
· the insurance industry as an intermediary of credit and market risk.

(1) The insurance industry (particularly life insurance) has been a major source of long-term capital.

· In this context, the industry could be viewed as a stabilizing element: it tended to fund its relatively long-term liabilities with long-term investments (mostly bonds and loans), and relatively little equity investments.
· During the 1990s, however, equity investments by life and non-life insurance companies rose considerably. As the past few years have demonstrated, life insurers may be prompted-in part by regulatory rules, such as "Regulatory Minimum Margin" in the U.K.-to sell equities into declining markets-with possibly some amplifying effect on equity price declines.

(2) The need to save costs and ensure better distribution has been driving a wave of consolidation between banks and insurance companies toward bancassurance.

· As a result of closer integration, insurance industry problems could in the future spread more easily to other financial sectors by creating difficulties for affiliated institutions that are part of the same large complex financial institution.
· The links between the different sectors do not have to be strong; in fact, the perception of such links may be sufficient to cause "contagion" between banking and insurance, especially in times of broader market stresses.

(3) Most importantly, the insurance industry has become an important intermediary of financial risks.

· Insurance companies are increasingly active in financial transactions that create counterparty exposures vis-à-vis banks, particularly in markets for OTC derivatives and other complex financial products. Many of these activities, particular credit risk transfers, are partly driven by "regulatory arbitrage" based on different regulatory regimes for banks and insurers (specifically capital adequacy rules).
· Insurance companies are major intermediaries of retail savings and are large holders of financial instruments. Therefore major purchases or sales by them could create market volatility.
· As a result, developments in the insurance industry have potentially systemic ramifications for the financial system as a whole.

It also could lead to a more concentrated allocation of risks:

· On the one hand, insurance companies can off-load some insurance risks in financial markets by securitizing insurance risk (e.g. catastrophe bonds).
· But on the other hand, financial market activities can shift risk to the insurance sector when insurers, for example, become sellers of credit protection-absorbing a type of risk that has traditionally been borne by banks.

As the allocation of risks across different parts of the financial system changes, the effect of financial shocks is also being altered. While it used to be unlikely that banking and insurance sectors were affected by the same shock at the same time, in light of the convergence of their risk profiles, including cross-shareholdings between institutions, banks and insurers may increasingly be affected by similar shocks. This could possibly reduce the resilience of the financial system as a whole.

A key question is: are the risks, including credit risks, more efficiently distributed to those willing and better able to bear the risks?

· The assumption of credit risk by insurers may provide risk diversification from the perspective of the insurance industry.
· It may also provide diversification for the market as a whole, by sharing some of the risks formerly held by banks.
· But these risks may have become more concentrated amid consolidation in the global insurance and reinsurance industry: a few large reinsurance companies experiencing financial distress could pose risks for the counterparties of their financial market operations-and banks in particular.

Another question is: are insurers equipped to manage the new risks that they assume?

· Relatively little is published about insurers' internal risk management and control systems for managing their asset market activities, and credit risk more specifically. For this reason, the Financial Stability Forum is taking stock of how to improve public disclosure and aggregate data on credit risk transfer activity so as to judge whether the risk has really gone to those that can best bear it.
· Some observers question whether risk management of insurers has kept pace with their expanding involvement in financial markets, the size of their off-balance-sheet activities, and the migration of financial risks from banks to the insurance industry.
· Many credit risk transfer activities, in fact, straddle what would traditionally be considered "underwriting" and "investment" activities and therefore require more integrated approaches to risk management (as a recent IAIS report to the Financial Stability Forum emphasized).
· It is in the private sector's own interest not to wait for legislators and regulators to tell them what to do. The private sector should itself be proactive in providing transparent information about credit risk transfer.

These systemic concerns have implications in at least two respects:

· for the way insurance regulation and supervision is conducted; and
· for the type of financial information insurance companies should disclose.

In general, much less is known about the financial activities of insurance and reinsurance companies than that of commercial and investment banks. This is in part because the regulatory and supervisory framework for insurance is primarily oriented toward policyholder protection and less focused on how insurance companies manage their financial risks:

· Capital/solvency requirements in many jurisdictions almost exclusively reflect insurance risks-the liability side of the balance sheet-rather than investment risks.
· Official oversight of the insurance industry tends to be much less focused on financial market risks than the official oversight of commercial banks.

The first implication is therefore: as financial risks gain importance, it is necessary that the focus of insurance supervision shift toward assessing financial risks.

I therefore welcome that in the context of the revisions to the Insurance Supervisory Principles (which will be completed in October), explicit emphasis is being placed on financial risk management by insurers and market analysis by supervisors.

A second area of improvements is disclosure and transparency of financial market activities of insurance companies, which at present appears to be insufficient for their new role in the financial system.

· On the whole, information on the investment risks and on off-balance-sheet exposures is relatively limited.
· In addition, features of accounting standards, such as the often complex actuarial assumptions underlying valuations, may complicate oversight by outside investors.
· Supervisors and market participants also need more information about insurers' internal risk control systems for managing their financial market activities.

The second implication is therefore: the increasingly important role of insurers as intermediaries of financial risk should go hand in hand with increased disclosure of their financial risks-both for on-balance-sheet positions and off-balance-sheet exposures.

Welcome steps are being taken to enhance transparency and disclosure, particularly in the reinsurance sector. A system is currently being developed to produce global reinsurance market statistics and analysis that can be used by financial stability authorities, market participants and the general public. Discussions are underway with industry representatives and the key reinsurance supervisors on global reinsurance market statistics and appropriate public disclosure.

II. Fair Value Accounting and the Sharing of Risk over Time

Let me turn now to my second subject: some effects of fair value accounting.

I want to highlight one special aspect that may not have received much attention in the debate: the implications of fair value accounting on the insurance industries' role for sharing risk over time (intertemporal risk sharing) as opposed to standard risk pooling (cross-sectional risk sharing).

By risk sharing over time, I mean, for example, the situation when policy holders are offered rates of return that are smoother over time than the investment returns of the insurer.

While cross-sectional risk sharing is the core business of both life and non-life insurance, the risk sharing over time is often more implicit.

Risk sharing over time is a result of mismatches between an insurer's assets and liabilities and is therefore linked to one of the key concerns expressed about fair value accounting: namely the fact that reported earnings would likely become more volatile as values of assets and liabilities behave differently. To the extent that the higher earnings volatility stems from an asset and liability mismatch, it is in large part a real risk and is the result of risk sharing over time provided by the insurer.

Fair value accounting will likely make this intertemporal risk sharing more explicit and apparent, and would reveal its costs more clearly. This type of risk sharing would therefore likely be priced by the market more appropriately.

Overall, financial efficiency might be enhanced.

III. Fair Value Accounting-Is There Room for Some Middle Ground?

Although in principle more accurate measurement of asset/liability mismatches is likely to improve transparency and market efficiency, there are still practical questions about the best measurement approach.

When I consider the debate about the benefits and drawbacks of fair value accounting, and when I listen to the previous speakers outlining the problems that could arise, I wonder whether there is scope for some middle ground.

It is probably relatively uncontroversial that market values of assets and liabilities, at any one moment, may not indicate the long-term health of a firm if they represent transitory short-term volatility or if market prices are in some way distorted. This is especially true for long-term assets whose prices may be particularly volatile.

Therefore, a snapshot of market values may, in fact, not capture accurately the financial condition of an insurance company, and could, in a worst case, be misleading to outside observers.

Given the increased volatility of capital markets in recent years, unnecessary noise arising from temporary fluctuations in the valuation of financial intermediaries' balance sheets could, if markets overreact, add to financial stability risks in the system.

There may be scope for supplemental accounting information that would

· preserve an appropriate degree of transparency while softening the apparent volatility of results,
· prevent misleading accounting results from causing unwarranted market reactions, and
· avoid premature supervisory requirements to sell assets that might worsen the long-term financial condition of insurers and could adversely affect financial market conditions generally.

It might thus be useful to consider ways to make valuation methods a bit more stable, or at least ways to explain the context of the fair value results so that investors and analysts can interpret the figures from a longer-term perspective.

To address some of these concerns, various approaches could be considered that could smooth the more extreme effects of marking to market and could provide supplementary information (including how model-based valuation results vary with changes in underlying parameter values) so that investors reach more balanced conclusions.

On the asset side, one could consider valuing financial assets that are traded on secondary markets (such as equities) based on some average of market prices over time.

· Averaging over relatively short periods (say, from 1 week to 3 months) would greatly reduce day-to-day noise in asset prices.
· Alternatively, the averaging could also be done over longer-term periods (say, up to one year) to smooth out some of the effects of the financial cycle-though under normal circumstances it might be hard to justify that up-to-date market price signals should be ignored for such extended periods of time.

These averages could be provided either as supplemental, more stable, results to act as background information for the latest mark-to-market figures; or they could even be used in the main earnings calculation itself.

In another approach, financial assets could be grouped into different "books," such as a trading book and a long-term investment book. While assets in the trading book would be marked to market, assets in the long-term investment book could be valued on an amortized cost basis. The investment book need not involve only assets being held to maturity, but also those being used for specified investment needs with a long horizon.

On the liability side, where models will largely have to be used to value insurance obligations, supplemental explanations could describe the sensitivity of liability values to key changes in parameter values of the pricing models. This would give a clearer idea of the degree of uncertainty behind the earnings data, and their sensitivity to long-term assumptions.

More generally, financial reporting based on alternative assumptions could be presented as an important part of an insurance company's explanation of factors behind its latest earnings announcement. Disclosing the sensitivities of some key asset and liability values to underlying factors, such as interest rates, would be very instructive for investors.

Some type of dual reporting would be particularly important during the transition phase between 2005 and 2007 if fair value accounting would apply to the asset side but not yet to the liability side, likely causing particular volatility in earnings.

There is a particular concern among some that fair value calculations could cause insurers to breach regulatory limits too easily, and force them to sell assets into falling markets. This could be safeguarded against both by using more stable valuation methods for the purpose of regulatory limits than for reporting the published accounts, and by allowing appropriately long periods for companies to adjust their holdings, perhaps after case-by-case consultation with supervisors.

In sum, I see some possible scope for a middle ground. There are ways to supplement fair value reporting with information that would enable investors to take an appropriately longer-term view of the financial health of an insurance company and the insurance industry as a whole.

¹ The views expressed are those of the author, and do not necessarily reflect the views of the IMF.