“One of the most important changes in recent years in the international financial system,” observed the IMF’s Hung Tran, “has been the blurring of the demarcation line between different sectors of the financial services industry.” The use by banks of credit derivatives first caught everyone’s attention, he said, but perhaps a more important development has been the “steady, relative reallocation of credit and other risks from the banking sector to various non-banking sectors, including the insurance industry.”
Just how large has this transfer been? The U.S. insurance industry, for one, has for the past couple of years held more nonfarm corporate credit risk than the U.S. banking sector. The transfers of risk to the insurance sector, Tran said, naturally raises questions. And the transfer of credit risk to nonbanking sectors more broadly raises questions about whether risk has been reduced for the overall financial system, or merely shifted to less transparent sectors, with different systems of regulation and, in some cases, less developed credit risk management skills.
For the IMF, this transfer also raises questions about its effect on global financial stability. In the interest of learning more about the new factors shaping financial market activities and of deepening its understanding of risk taking and risk management, the IMF’s April 2004 Global Financial Stability Report included an in-depth look at developments in the insurance industry, and a similar study of the pension industry will be published in September 2004. On the insurance industry, the IMF’s key findings included the following:
• differences in market characteristics and in regulations were factors behind the sometimes significant differences in the composition of asset portfolios across countries and regions;
• credit instruments are appropriate for the life insurance industry, given the nature of many of its liabilities;
• where credit markets are more developed, insurers have developed greater credit management capabilities and allocate a larger share of their asset portfolios to credit instruments;
• insurance sectors in countries with more developed credit markets and with a larger share of credit instruments in their asset portfolios have tended to be more stable; and
• in light of their experience during the equity market downturn of 2000–02, many insurance companies—particularly in Europe—have increased capital, strengthened risk management, and allocated more of their assets to credit products—that is, corporate bonds and other credit instruments, including credit derivatives.
All in all, these developments have, according to Tran, reduced the risk of balance sheet pressures in the insurance industry. Given also the recently demonstrated strength of the banking sector, the transfer of risk has been, on balance, “a positive development from the point of view of global financial stability.”
Sea change in risk management
According to AIG’s Director of Market Risk Management, Charles Lucas, the insurance industry is undergoing a huge change in the way it manages risk. It now talks of asset and liability risk much as a finance theorist would. AIG, for example, employs a small army of PhDs in mathematical physics and applied mathematics to build risk management models.
Much attention has been devoted to credit derivatives, but Lucas cautioned against overplaying their role in the insurance industry. It is on the liability side—particularly for life insurance and annuities—that “capital market technologies are invading traditional businesses and causing companies to completely rethink the way in which they construct and risk-manage classes of products.” Insurance products are a class of exposure that is appropriately modeled by finance theory-based models (that is to say, inherently stochastic models), while actuarial approaches tend to be deterministic. Indeed, life insurance and annuity products provide benefits and related product features and rights that, for all intents and purposes, are quasi-financial options. What insurance firms are doing, he said, is taking standard finance theory in capital markets, modifying it as appropriate for an insurance contract, and estimating fair value and risk. This then becomes the foundation for hedging of risk using capital market instruments directly. It is in this form, he explained, that “capital markets are really penetrating the insurance industry most immediately.”
The largest question associated with this trend, in Lucas’s mind, is the degree of “culture change” it will entail. He equated it to the sea change that the banking industry experienced 20–25 years ago when financial options appeared and the industry had to learn to think in very different ways and to develop very different analytical tools. Traditional insurance exposure is inherently diversifiable. Option risk, however, is generally not diversifiable, and that is why “it is so difficult to change the way in which these risk management approaches are executed within an insurance company.” You have to think about the problem in “a completely different way and manage the risk in a completely different way.”
In the view of Keith Buckley, a Managing Director of Fitch Ratings, credit derivatives have “significant implications for different sectors and different companies in the insurance industry.” He saw the rapidly growing and relatively new market as having the potential for the concentration as well as the dispersion of risk, and he pointed to potential areas of concern—notably information asymmetries, little transparency and disclosure, and the difficulty of tracking credit derivatives by region and sector.
In a survey of the global credit derivatives market published in 2003, and now being updated, Fitch found that global credit risk is being transferred to a variety of nonbanking institutions, including financial guarantors, the insurance and reinsurance industries, and regional banks. The key issues that emerge from the Fitch study, Buckley said, fall into the areas of information and risk management, financial disclosure, and hedge fund activity.
In terms of risk management, he saw most insurance companies as doing a “reasonably good job.” There were, to be sure, varying levels of sophistication, but the less sophisticated also tended to have relatively modest exposure. He was less upbeat on the disclosure front, where he argued that “if you are an outsider looking in and relying solely on public information disclosure, you are unlikely to fully understand what companies are doing” in “shaping and reshaping their risks, and what type of risks they are taking on.” That is why, he said, Fitch is pushing hard for better disclosure for outsiders—investors, rating agencies, and the like—to be better able to understand the flows.
And should there be concerns about hedge funds? Anecdotal evidence suggests they may account for 20–25 percent of credit derivative activities, but they did not participate in the survey and tend to be secretive. Buckley added that this simply reinforces the importance of the disclosure issue and the need for more research and continued attention to the broad issue of credit derivatives.
Both supervisors and rating agencies are meant, in their different ways, to keep an eye on risk management in insurance companies. But, just what does a rating agency do? According to Standard & Poor’s Grace Osborne, the ultimate goal of a rating agency is to “develop a timely, objective, well-informed assessment of the credit risk” associated with the company or issue being rated, and to provide this to the market so that participants can make informed decisions.
It’s an open process, she added, and all of S&P’s ratings and models are posted on its website. And the approach is global and systematic, examining competitive position, management and corporate strategy, operating performance, investment analysis, capital and reserve adequacy, and liquidity or financial flexibility.
When S&P goes into a life insurance company, it tries to figure out what capital is needed, given the risks being assumed. The factors impacting a rating vary, reflecting S&P’s assessment of the associated asset default risk (for credit instruments) or volatility (for equities). And these individual assessments, taken together, also paint larger regional and international trends. Osborne noted, for example, that the North American insurance sector is currently rated higher than its European counterparts, whose equity-heavy investment portfolios were hit hard and whose capital positions were devastated in 2001 and 2002.
But the industry learned from the recent experiences and, in S&P’s judgment, is in better shape today. Osborne saw strong, recovering capitalization; good credit trends; clearly improved asset quality; and greater operating efficiency. And S&P saw these trends continuing in a climate of a gradual rise in interest rates. But there are challenges ahead. Credit spreads have tightened and any sharp rise in interest rates could, she cautioned, have an adverse impact. She also saw evidence of increasing “product risk,” and reinsurers backing away from certain products and markets.
A regulator’s perspective
How can a regulatory structure help to support risk management? David Strachan, Director at the U.K. Financial Services Authority (FSA), acknowledged that the life insurance industry in his country saw its struggle with the 2000–02 bear market complicated by a relatively unresponsive capital regime.
What the FSA did, in response, was to suspend its stress test—related constraints and allow individual companies to apply for an exception to some of the rules, if and while they upgraded their risk management systems—all of which produced a “significantly beneficial effect on the market.” The United Kingdom is now moving to a new capital adequacy framework, whose major changes will include: requiring insurance companies to use more modern techniques for valuing options and guarantees, specifically provisioning for expected discretionary payments on insurance products; and insisting on an explicit capital requirement—a capital buffer—for investment risks.
But moving to a much more risk-based capital framework is bound to have some effects. In particular, it is likely to entail rebalancing of portfolios (with the portion of equities dropping from 70 percent at their recent high) as well as hedging of market and other risks, and a reduction in certain policyholder benefits and products.
Tran wound up the panel’s presentations with a provocative question. Are rating agencies effectively playing the role of regulators? Buckley, speaking from Fitch’s perspective, said: “We don’t consider ourselves regulators, we do not want to be regulators, and we don’t want to be characterized as regulators.” Fitch can rate companies and seek voluntary information. It cannot demand or subpoena information or cause insurance companies to take action. But that said, Buckley added, Fitch is pressing its analysts to identify situations on a prospective rather than reactive basis. Osborne essentially agreed, while also acknowledging the influence rating agencies can exert and the capacity they have to develop ways of looking at risk and applying them across the entire sector. Buckley cautioned that the real problem would be the difficulty that both rating agencies and regulators have in assessing the models for capital adequacy and other risks that insurance companies are using. Information is hard to come by, and the range of models in use is “proliferating.” The bottom line, he said, is that the overall assessment of risk models is getting more difficult for both rating agencies and regulators.
For his part, Strachan said he would be “delighted to exchange my postbag of letters from policyholders and members of parliament” with those of S&P or Fitch. He also acknowledged that rating agencies provided a strict and complementary discipline over insurers’ capital. Going forward, he saw complementary responsibilities for rating agencies and regulators, not least because regulators perform functions outside rating agencies’ remit, such as consumer protection, but with rating agencies enhancing the effectiveness of market discipline.