Systemic risk in banking and insurance
Financial institutions such as banks and insurers are, of course, constituents of the wider capital market. Thus, in addition to their firm-specific risks, they are exposed to market volatility and correlation.
Observed volatility in capital markets such as the recent “credit crunch”, which was largely generated by substantial declines in the value of derivatives (collateralised debt obligation/Asset-backed security: CDO/ABS) with underlying U.S. subprime real estate collateral, can leave firms exposed to systemic risk.
However, the term “systemic risk” is somewhat ambiguous with regard to both its definition and derivation.
A widely accepted definition of systemic risk is that of Csiszar18 who characterise it as “the risk that the failure of a participant to meet its contractual obligations may in turn cause other participants to default, with the chain reaction leading to broader financial difficulties”.
However, this definition includes only the sort of “micro” systemic risk represented by a cumulative loss function caused by a domino effect, as illustrated in Figure 6. The alternative form of systemic risk, known as “macro-systemic risk”, is one which is not dependent upon a cumulative loss function.
In this instance, a single exogenous event leads to simultaneous adverse effect on multiple entities. This was precisely the case during the Lehman bankruptcy in September 2008, which sent a systemic shock throughout the credit market, restricting global liquidity.
In this paper, we use the term systemic risk to include both its “micro” and “macro” forms. Systemic risk is traditionally regarded as a phenomenon most present in the banking sector. This view is supported by the direct positive correlation found in historical equity returns as well as counterparty credit links established by inter-bank lending markets.
The recent subprime crisis was only one of many historical events that highlighted this web of exposure between banks, ultimately leading to multi-billion write-downs in securitised trading assets and trillions being wiped of international equity markets.
However, unlike many past crises, the U.S. subprime crisis had a far wider impact than in the banking sector alone. Insurers, which were typically regarded as a being largely segregated from the rest of the financial industry, experienced significant write-down losses on their investment portfolios.
AIG became the most notorious case when it was bailed out for a record US$85 billion by the U.S. government following its inability to meet its investment obligations (in particular regarding its CDS contracts).
Prior to the recent financial crisis, the insurance sector was believed to be largely immune to systemic risk. The lack of a significant “insurance crisis”, as discussed in the section “Previous insurance ‘crises’ ”, suggested that the risk of systemic failure was minimal in the insurance industry.
Certainly, unlike banks, insurers do not face the risk of financial runs caused by clients withdrawing funds when they begin to fear that the firm will not be able to meet its contractual obligations. Instead, insurers are only obliged to pay when a client suffers a loss on an existing policy (in the case of non-life insurance) or on death of the insured or maturity of the plan (in the case of life insurance).
Of course, insurers are exposed to the underwriting cycle, with alternating periods of soft markets (low premium) and hard markets (high premium), as illustrated in Figure 7. The insurance industry is equally susceptible to the effects of major disasters that they sell protection against.
Furthermore, over the last decade the magnitude and frequency of such fundamental risks faced by insurers have undoubtedly increased, partly as a consequence of an increase in man-made catastrophes, such as terrorist attacks, and partly through the concentration of insurance risks in danger zones.
As a result of this increased exposure, insurers have turned more and more to the capital markets and alternative risk transfer (ART) mechanisms to mitigate the impact of catastrophes on their balance sheet.
ART gives insurers access to financial markets where they can directly transfer and finance their risks using instruments such as CAT bonds and insurance-linked securities (i.e. insurance funds). This movement towards the capital market has increased the exposure of insurers to the banking sector, which acts as the counterparty to capital market arrangements made by the insurer via ART investments.
As a consequence of this extension in activities, there is a copula effect between the banking and insurance sector. Table 1 shows the average equity correlation between a selected group of banks and insurers between 2004 and 2009.
As shown above, the average correlation between banking and insurance equity values has increased significantly in recent years, with a correlation delta of 86.1 per cent (2004–2009). It must be noted, however, that this result does not suggest that the insurance and banking industries face systemic risk in pari passu manner.
The banking sector is more susceptible to systemic risk due to lower capital to asset ratios, lower levels of cash reserves and the highly structured and illiquid instruments traded by banks.
Nevertheless, this result does suggest that the insurance industry’s pursuit of capital investment as a value driver to compensate for underwriting results has resulted in its being exposed to market risk, which can be defined as “potential losses owing to detrimental changes in market prices and/or other financial variables influenced by prices”.
This is precisely what has happened with the recent subprime crisis, where the decline in the value of CDOs and ABS led to write-down losses suffered by both banks and insurers. Along with increased participation in capital market instruments, the insurance industry is further aligned to risks faced in the banking sector, including systemic risk, through the significant holdings they have in banks.
Such holdings will clearly leave insurers’ own performance subject to that of the banking sector. A relevant example is found in the German insurer Allianz SE that owned outright Dresdner bank in the period between 2001 and 2008.
In this case, Allianz suffered a negative impact on its equity and balance sheet as well as key capital ratios following multi-billion writedowns by its banking subsidiary. Table 2 shows the average correlation/beta/R2 between a selected group of global bank and insurance indices in the period 2007–2009.
The results above suggest that there is a relatively strong correlated relationship between the performance of the banking and insurance indices, with each index acting as a relatively strong determinant on the performance of the other.
In particular, the BBG World Insurance & BBG World Bank indices have a regression/correlation estimation of 85.8 per cent/92.6 per cent while the Citigroup Eurostoxx Insurance & Bank indices have a regression/correlation estimation of 80.8 per cent/89.9 per cent, respectively.
The copulament between the banking and insurance sector is further illustrated by the historical analysis of the S&P500 Banks (S5BANK) and S&P500 Insurance (S5INSU) indices. Figures (8)–(10) show the historical correlation/price movements of the two indices as well as their regressive relationship in the period 2004–2009.
As we can see from Figures (8–10) and the results in Table 3, there is a strong positive correlation between the two indices.
The movement of the two indices during the assessed period signifies a bivariate normal distribution with the two indices indicating a strong explanatory relationship one upon the other.
The only key outlier in the results is during 2005, where the correlation between the two indices decreased due to the losses sustained by the insurance industry, following Hurricane Katrina. This loss was a result of underwriting risk, which was specific to the insurance industry.
The underlying relationship between the banking and insurance sector is quite obvious from the above analysis, and the relationship has clearly strengthened during the last decade.
As we have seen, this relationship has arisen both from the insurance sectors’ growing participation in the capital markets and its adoption of bancassurance models, together creating a systemic link between banks and insurers.
However, the systemic risk arising from bancassurance activities may well diminish in the aftermath of the financial crisis, following significant withdrawals from the banking sector by a number of insurers. This is considered in the final section of our paper.
Reinsurance and systemic risk
From the analysis above it is clear that insurers face greater systemic risk from their affiliations with the banking sector than from within the insurance sector itself. This is largely because there is limited trading between insurers.
As underwriting risks are not usually transferred between carriers, credit risk is minimal. However, there is obviously an exception to this rule, in the shape of reinsurance and retrocession.
Reinsurance, in essence, is insurance for primary insurers, whereby the latter, for a premium, cede away some of their underwriting risk (normally large/complex risks in concentrated areas) to reinsurers that, in turn, may further cede parts of the risk to other reinsurers (retrocession).
On average, 6 per cent of risk is transferred worldwide by primary insurers to reinsurers, which in turn transfer approximately 20 per cent to other reinsurers. This process of risk transfer between insurers and reinsurers, and reinsurers to other reinsurers, poses the question of whether a systemic link is created.
The question for primary insurers is whether, by transferring a portion of their risk to reinsurers, a significance credit risk is assumed. For the reinsurer, there is also a potential credit risk in the shape of other reinsurers to which they in turn have ceded risk.
Furthermore, reinsurers are also significant participants in the capital markets as they, like primary insurers, try to diversify some of their risk via credit-linked securities. This link between the reinsurance market and the banking sector could further expose insurers to systemic risk.
In fact, earlier studies suggest that systemic risk posed by reinsurance is relatively weak. Insurers generally diversify their risk to multiple reinsurers, thus avoiding a large-scale credit risk with any particular reinsurer.
Reinsurers further diversify their risk by holding a diversified pure risk (e.g. earthquakes, fire and liability) portfolio, thereby mitigating the prospect of multiple large-scale losses.
According to a study by Swiss Re,22 only 24 reinsurers failed in the period 1980–2002 and these failures affected on average only 0.02 per cent of the total premiums transferred to reinsurers in this period.
Table 4 shows the correlation/R2 estimates between insurers and reinsurers for the underlying CDS (five-year spread) and equity for the period 2007–2009.
As we can infer from the results, the performance of insurers and reinsurers on both the equity and CDS sides are largely independent of each other, suggesting little influence and hence little systemic link, which confirms existing studies.
On the other hand, the correlation results suggest that there is some degree of correlation in the equity and CDS values of insurers and reinsurers.
This correlative link is probably due to the credit link that both the insurance and reinsurance markets have with the banking sector as a result of their risk diversification strategies via the capital markets.
It would seem, therefore, that the potential for systemic risk in insurance and reinsurance networks could only be realised by either an unanticipated exogenous shock far greater than any that has yet occurred or in a case where the reinsurer was part of a financial conglomerate.
If a reinsurer had a stakeholding relationship with another financial conglomerate, for example a bank/insurer, then the bankruptcy of the reinsurer could result in reduced confidence in the bank/insurer’s credit worthiness.
This potential for systemic risk would be reduced if the use of shared capital between conglomerates was prevented.
Systemic risk in life and non-life insurance
In this section, we aim to compare the degree of systemic risk within life and non-life insurance markets. In principle, systemic risk would seem to be of much greater concern in the life segment, owing to the greater level and diversity of its investments.
Non-life involvement in the capital market is predominately based on derivatives with underlying insurance events acting as triggers. Let us take the CAT (catastrophe) bond as an example. Here the insurer issues the bond and transfers the cash inflow from the issue to a Special Purpose Vehicle (SPV).
The insurer will continue to pay the investors interest via the SPV until a disaster occurs. If the disaster occurs the insurer will stop paying investors and use the issue proceeds from the SPV to offset the claims made in conjunction with the disaster.
The risk here lies with the investor and not the insurer. The insurer is only exposed to risk if the issue proceeds are invested in securitised funds with low-rated collateral. However, normally the issue proceeds are invested in risk-free treasury bonds issued by AAA-rated governments such as the United Kingdom or the United States.
The situation is different for life insurers that invest in underlying securities that are subject to market volatility, such as corporate bonds.
Life insurance products are based on the duration of human life and promise to pay fixed sums, set at inception of the contract, such payments not being so subject to the random occurrence of an unknown event.
Therefore, life insurers invest in bonds and funds to achieve a rate of return requisite with their future obligations. These forms of investment carry a higher degree of market risk than non-life investments, which makes life insurers more susceptible to systemic risk during periods of market downturn.
To test the validity of this thesis, the U.K. FTSE 350 Life and FTSE 350 Non-life insurance indices were observed from 2004 to 2009. Figure 11 and Table 5 show the historical price movement of the two indices.
As we can see, the life insurance index experienced greater volatility than the non-life index during market downturn, especially in 2008 during the equity market slump following Lehman Brothers’ bankruptcy and the near-demise of AIG.
This observed volatility for the life index is a direct result of life insurers’ aggressive investment strategies in the bond, equity and fund markets in which non-life insurers were only minor players. Such volatility in investments ultimately makes life insurers more susceptible to systemic risk than non-life insurers.
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