The contribution of life insurers to systemic risk has increased, according to the IMF Global Financial Stability Report. They now hold about 12% of global assets and common exposure to aggregate risk has risen. Insurers are vital for key market segments such as corporate bonds and securities lending. Meanwhile, low global interest rates have aggravated duration gaps, increased interest rate sensitivity and may encourage greater risk taking.

Chapter 3 of IMF Global Financial Stability Report, April 2016.

The below are excerpts from the Global Financial Stability Report. Headings, links and cursive text have been added.

Why insurance companies are a systemic concern

“Insurance companies…are a major source of long-term risk capital to the real economy, and are among the largest institutional investors, holding about 12 percent of global financial assets, or USD24 trillion of which life insurance accounts for 85 percent…The asset size of some insurance firms rivals that of the biggest banks and may create too-big-to-fail-type risks…Life insurers hold large amounts of government and corporate bond debt, and in the United Kingdom and Japan they also hold major stakes in equity markets. Insurers’ share in direct lending is small, but it is rising in many countries.”

“When considering debt-to-asset ratios, insurance firms’ leverage is usually much lower than that of banks…However, leverage including insurance liabilities is close to that of banks.”

Insurers are interconnected through reinsurance relationships and retrocession arrangements, and with the wider financial sector through various other channels. In many countries, they are important holders of bank debt and they are often linked to banks through ownership ties or counterparty exposures such as derivatives transactions or securities lending.”

“The contribution of life insurers to systemic risk has increased in recent years…due to growing common exposures to aggregate risk, caused partly by a rise in insurers’ interest rate sensitivity… In the event of an adverse shock, insurers are unlikely to fulfil their role as financial intermediaries precisely when other parts of the system are also failing to do so. Given insurers’ significance as funding sources… the effects on the real economy could be important…. Insurance companies play a critical role in corporate bond markets, and a cessation of funding that may arise from a shock to insurance company balance sheets could have extensive repercussions…[Also] insurers may, for example, stop lending securities to counterparties.”

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“Life insurers’ equity price co-movements have increased… a higher correlation of insurers’ stock prices among themselves and with the market implies that more insurers are more likely to be hit by the same shocks at the same time, and they will tend to react more similarly when hit by a shock.”

“Anecdotal evidence suggests that lapses [cancellations that insurers’ aggregate risk position] on life policies are becoming increasingly likely, as early withdrawal penalties are reduced in some countries…The likelihood of lapsing will vary with economic and market conditions, which help determine the extent to which more attractive alternatives to an existing policy are available. Up to 50 percent of European life insurance policies are estimated to be cancelled without penalty.”

Measuring systemic risk contribution

Life insurers’ contribution to systemic risk, as measured by a comparison of value-at-risk measures (ΔCoVaR), has tended to increase in Europe and North America. In these regions, indices indicate that the average systemic risk contribution has returned to historically high levels. It is two to three times higher than in 2006.”

“An alternative gauge… quantifying the systemic risk of a firm (SRISK) by its expected capital shortfall conditional on a prolonged market decline…also suggests that insurers’ contribution to systemic risk has grown although remaining smaller than that of banks. The SRISK approach measures systemic risk through a firm’s contribution to the aggregate capital shortfall of the financial sector. A capital shortfall occurs if a firm’s losses are greater than the excess of its actual capital over its required capital. The capital shortfall is a function of the size of the firm, its leverage, and its expected equity loss, conditional on the market decline.”

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“Banks dominate the systemic risk rankings, but the representation of insurers among the top 100 firms has grown since 2001. In particular, life insurers have tended to be more systemic and nonlife insurers much less systemic than their sample shares suggest.”

The duration gap issue

The current prolonged period of low interest rates challenges life insurers’ business model because their promised rates of return on long-term contracts exceed the returns on available ‘safe’ assets (sovereign bonds and high-grade corporate bonds).”

“Because of imperfect asset-liability matching (duration mismatches), life insurers have become increasingly sensitive to interest rates as interest rates have fallen…Any existing duration mismatch will worsen with a decline in interest rates since the duration of long-term liabilities rises more than that of shorter-term assets. This effect is more pronounced when the level of interest rates is low—that is, any further fall in interest rates will result in a sharper increase in duration mismatches.”

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“The low-interest-rate environment has raised concerns about the solvency of firms in various insurance markets, and such firms may be induced to take on excessive risks….Firm-level case studies suggest that, as interest rates decline, particular types of firms—smaller life insurers, those with weaker capital positions, and those with higher shares of guaranteed liabilities—tend to take on relatively more risk…Lower interest rates exacerbate the incentive for weaker insurers to gamble for resurrection.”

Regulation effects

Insurance solvency regulations have become more risk based and thereby have affected insurers’ investment choices. Risk-based capital and reserve requirements have been introduced in many countries.”

“The 2006 Swiss Solvency Test and the 2016 Solvency II Directive of the European Union effectively introduced market-consistent valuation of the total balance sheet. The valuation of liabilities is affected only by the safe interest rate, whereas the valuation of risky assets is also driven by credit spreads (an issue particularly relevant for assets with long maturities). Therefore, insurers have fewer incentives to invest in return-maximizing risky assets so as to avoid large shifts in capital requirements. At the same time, market-consistent valuation encourages investments in longer-term, low-risk assets, such as sovereign debt and high-grade corporate bonds, and these incentives become stronger the higher the market volatility.”

“Regulatory regimes differ widely across countries, which may lead to regulatory arbitrage”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.