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Insurance, Systemic Risk and the Financial Crisis

Insurance, Systemic Risk and the Financial Crisis

Historically, there has been a distinct separation between insurance, banking and other financial markets in most countries, so that events in one sphere usually had little effect on the other. 

However, in recent years the barriers between insurers, banks and other financial firms have been partly dismantled, resulting in much closer affiliations between them and more linkages and overlaps in their activities. 

This phenomenon, which is partly, but not wholly, encapsulated in the term “bancassurance”, began at an earlier date in Europe than in the United States, and earlier still than in major Asian markets such as Japan and Korea, where legislation separating banks from insurers has existed until very recently. 

However, given that the barriers referred to above have been at least partly removed in many countries, we may well ask whether the current financial crisis, which began mainly in the banking sector, has spilled over into an “insurance crisis”, and whether this, in turn, has made the whole financial crisis worse. 

As we shall see, the financial crisis has indeed impacted on insurance markets to a significant degree and events in insurance markets have, in turn, affected the way in which the crisis has developed. 

However, the impact of the crisis on insurers has been very uneven: in some parts of the insurance market the effects have been relatively muted, in other sectors they have been severe. Our paper is structured in five parts. 

We begin by briefly examining some previous insurance “crises” and then go on to consider the effect of the current upheaval on insurance risk; that is, the effect of the crisis on the underwriting activities of insurers and the liabilities they assume thereby. 

Lines of insurance that have been particularly affected are identified and discussed. We then move on to consider the effects of the crisis on the performance of insurers in different market sectors and in different parts of the world, comparing their performance with that of banks at various points. 

We then move on to consider the general question of systemic risk in the field of insurance, discuss the main sources of such risk and assess the extent to which, if any, it has expanded. In our conclusion, we summarise the effects of the crisis on insurance markets and consider the structural changes that we are likely to see as a result.

Previous insurance “crises” 

Has there ever been an “insurance crisis” that parallels the “credit crunch” and connected events in the banking world? Certainly, there have been a number of upheavals in insurance markets that some, at least, have described as “crises”: that is, periods characterised by the failure (or near failure) of one or a number of insurance firms, reduction in the supply of insurance and significant disruption of economic activity. 

A notable example is the 1984–1986 U.S. “liability insurance crisis”, during which U.S. property/casualty insurers made huge losses and insolvencies became commonplace. As a result, insurance capacity dwindled alarmingly as insurers (and reinsurers) attempted to restore profitability. 

The causes of this “crisis” are still disputed,1 but reported effects included, inter alia, the closure of some children’s playgrounds when insurance for them became unobtainable and rocketing premiums for medical malpractice insurance, which allegedly led to rise in “defensive medicine” and diverted physicians away from those branches or medicine where premiums were most punitive. 

The near collapse of the 300-year-old Lloyd’s insurance market in the early 1990s provides another interesting example of a major upheaval in the world of insurance. 

Injudicious underwriting, an exceptional number of major catastrophes in a short space of time and internal management problems caused Lloyd’s collectively to make huge losses over the period in question (around GBd8 billion between 1988 and 1992), bankrupting many Underwriting Members and bringing Lloyd’s close to insolvency. In the end Lloyd’s did not fail. 

Rather, it recovered, restructured and reinvented itself, regaining its place in the world insurance market for large, unusual, extra-hazardous and internationally traded risks. 

However, had it occurred, the failure of Lloyd’s would have dealt a hard blow to the world insurance system by curtailing the supply of cover for the sorts of risks described above, which would have caused significant economic disruption. At this point, it is worth remarking an interesting parallel between one facet of Lloyd’s problems and a key source of the current financial crisis. 

This was the London Market Excess (LMX) reinsurance (or retrocession) “spiral” that developed at Lloyd’s in the early 1990s. Retrocession (the further transfer of risk by a reinsurer to another (re)insurer) enables risks to be spread more widely, but also creates a credit risk for the reinsurer concerned that could, in turn, impact upon cedants from which the reinsurer itself has accepted risks. 

The LMX spiral developed from the continued retrocession by Lloyd’s syndicates of much of their business, so that many syndicates underwrote again the very risks they had transferred, sometimes without knowing it. 

Commission was shaved off the premiums each time the risk was passed on, threatening to leave insufficient capital to pay for losses, and therefore contributing to the overall Lloyd’s crisis. 

This situation, with multiple participants parcelling up and selling on risks to the point where the players lose track of their own and others’ exposures effectively magnifying risk rather than managing it is obviously echoed in the frenetic trading of credit derivatives that played a major part in the current banking crisis.

In fact, reinsurance has been identified as one part of the insurance market where there is, at least potentially, some systemic risk. 

This is discussed later. In addition to the U.S. liability crises and the Lloyd’s near-debacle, there have been many other upheavals, sometimes affecting one line of insurance only (such as the product liability crisis of 1976–1977, and the shortage in terrorism cover following the events of 11 September 2001). 

However, these “crises” have been relatively short in duration and, more important for the purpose of this study, mostly local in terms of their impact.

Again, we should not confuse a sharp rise in insurance prices with a failure of supply. The cyclical nature of insurance is such that hard markets occur quite regularly, but it is rare indeed for any common form of insurance to be unobtainable at any price. 

We should also bear in mind that the direct economic disruption caused by insurance “crises” such as those described is unlikely to be as severe as the devastation that can flow from the drying-up of credit markets. 

The latter, we know well, can severely damage the real economy and trigger a worldwide recession. By contrast, even a massive rise in the cost of insurance is unlikely in itself to cause much damage to the real economy. 

This is so because the cost of insurance, relative to other costs, is quite small for most businesses. In any event, the fact that there has never been a major worldwide “insurance crunch” suggests that there are some fundamental differences between banking and insurance markets, with less risk of systemic failure in the case of the latter. 

Again, this is considered later in this paper. All this does not mean that the insurance industry has proved immune to the effects of the current crisis, nor does it mean that insurance markets and mechanisms have played no part in the crisis itself. 

The insurance industry has been affected in a number of ways. As we shall see, some insurers have moved away from “traditional” insurance risks and started to assume financial (and especially credit-related) exposures that are much more prone to systemic risk, thus aligning their fortunes more closely with firms in the banking sector. 

This is discussed in the section “Systemic risk in banking and insurance”. First we will consider how the financial crisis, and the deterioration in the risk environment that it has brought about, has affected the traditional underwriting activities of insurers.

Bona Pasogit
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