Macroprudential Supervision in Insurance

Theoretical and Practical Aspects

J. Monkiewicz, M. Malecki, J. Monkiewicz, M. Malecki, Kenneth A. Loparo, Marian Ma?ecki, J. Monkiewicz, M. Malecki, Marian Ma?ecki

• Publisher: Palgrave Macmillan
• Year: 2014
• Print ISBN: 9781137439093
• eBook ISBN: 9781137439109
• Topic: Business
• Subtopic: Financial Risk Management
• Index: Business

Macroprudential policies, tools and supervision have become important since the last financial crisis. This book addresses general and methodological issues and provides a framework for the analysis of macroprudential policies and supervision in insurance. It focuses on policy related issues and global level aspects of macroprudential in insurance.

Part I

General Issues

1

The Dynamics of the Safety Net in Insurance: Trends and Challenges

Marek Monkiewicz

1 Introduction

In 2011, the size of the global financial system constituted approximately 370% of the global GDP. However, if derivative trade had been included this would have pushed the value of the global financial system to well above 1,200% of the global GDP for 2011. Assets of the banking sector alone represented 480% of GDP in the UK, 494% in Switzerland, 311% in Germany and 82% in the US (IMF, 2013, p. 12). This dramatic increase in the weight of the financial sector has been accomplished over the course of the last 20 years or so. In the UK, for example, until the end of the 1970s the share of banking assets represented only 50% of the country’s GDP and has only rocketed since the 1990s (Haldane, 2009).

As a result, there is now a situation in which economic safety and the well-being of individual states and the global community is increasingly dependent on the safety of their financial systems. Yet, the safety of the financial system is not a subject actively and directly addressed in the current academic debate. Rather, it is discussed indirectly in the context of financial stability, systemic risk and the financial crisis, that is in the context of extreme situations. Moreover, such discourse has a tendency to concentrate on the banking perspective. Under these circumstances the safety of the financial system is largely identified in terms of its stability (Schinasi, 2004, p. 6).

Such a narrow approach to the financial safety is difficult to justify with regard to the non-banking financial sector, and insurance in particular. Its relevance to the financial stability and systemic risk is much less pronounced and defined. In addition, the safety of the financial system cannot and should not be measured according to its stability: there is more to it than that. Other elements to consider include macroeconomic, monetary, fiscal, geopolitical and treaty-related factors. All of them, whether as a whole group, individually, or a combination of a few factors, may influence safety of the financial system. The current financial, fiscal and economic recession in the EU may serve as a good illustration of this conclusion.

The safety of the financial system has a graduate nature and may represent various levels resulting, ceteris paribus, from policy measures applied.

When one restricts the attention paid to the private financial systems and markets the safety of the financial system may be defined as a situation with the following attributes (Iwanicz-Drozdowska, 2008, p. 26; Monkiewicz, 2013, p. 31):

1.there exist mechanisms and institutions which only permit market operation for selected financial companies;

2.market participants are well equipped with the relevant information for adequate risk assessment;

3.there exist mechanisms and institutions which permit safety control and monitoring and its repair/fixing whenever necessary, including mechanisms for the protection of the customers;

4.there exist mechanisms and institutions for the orderly resolution and market exit of inefficient companies, including their bankruptcy.

The safety of the financial system may be analysed at different levels – national, regional or global. It may also be discussed at a sectoral level, for example, in terms of: banking, insurance and securities industry.

The safety of the financial system depends on several determinants. Primarily it depends on the state and its policies: in particular macroeconomic, monetary, fiscal and treaty policies. It also depends on its financial policy and the architecture of the financial market. Particularly relevant are the shape and nature of its participants: their size, complexity, portfolios, and so on. An important characteristic is the level of market discipline. Additionally, it depends on the financial education of the market participants and their market behaviour, rules and customs.

Finally, the safety of the financial system depends on financial safety nets: the arrangements that are dedicated to this specific task on the stand-alone basis.

The purpose of this article is to analyse the evolution of this particular socio-economic public construct in an insurance context. We begin, however, by providing the framework by discussing the nature, functions and building blocks of the financial safety net across the whole financial industry. We also comment on its costs and unintended consequences. We then turn our attention to the insurance industry and investigate the relevance of this concept to the insurance world. Finally, we complement our discussion with some conclusions. We underline in particular the dynamic nature of the safety net and its growing coverage and complexity.

2 Financial system safety net: conceptual considerations

In spite of the rising popularity of the notion of a “financial safety net” in the context of financial systems and financial markets, so far there is not a consensus regarding its definition, nor is it yet a widely accepted concept (Zaleska, 2010, p. 172). In one of the first studies to focus on this topic, produced by The World Bank at the end of the 20th century, the financial safety net was concisely defined as all “financial regulations and institutions that seek to prevent or limit depositor losses in case of a bank failure” (Demirguc-Kunt and Huizinga, 1999, p. 14). Thus the safety net has been viewed in a narrow way covering only the banking sector and relating exclusively to the losses of depositors. The use of such a definition would be entirely wrong from the today’s perspective. Similarly narrow interpretations of the safety net have been proposed subsequently by some researchers (Kane, 2009). A somewhat broader interpretation of the financial safety net was offered by Brock, who defined it as “a set of institutions, laws and procedures that strengthen the ability of the financial system to withstand bank runs and other systemic disturbances” (Brock, 1999, p. 2). This definition already applies the concept of the “financial safety net” to the whole of the financial market and not exclusively to the banking industry, although banking asymmetry is still prevalent. Additionally the safety net in this approach is aimed more at failure prevention than crisis management. An important contribution made by Brock to the discussion on this issue is his observation that the putting in place of a safety net results in the transfer of risk from private players to the state, with both positive (enhancement of the financial system) and negative (moral hazard) consequences.

New elements in the discussion have been offered by Solarz who defined the safety net as “institutions and organizations which aim both to prevent the occurrence of disturbances in the payment system and financial intermediation activities as well as act in the crisis management phase to limit negative consequences of a financial crisis” (Solarz, 2005, p. 90). Thus, for the first time he includes the safety of the payment system within the protection offered by the safety net and explicitly relates the notion of the “safety net” to all financial intermediaries, including insurance. He underlines at the same time that strategic options for the construction of safety net architecture should be placed in a multidimensional space in which cost effectiveness, the safety of the system and the profitability of the financial institutions intersect. A broader perception of the financial safety net has been subsequently offered by Iwanicz-Drozdowska. She formulates the opinion that “safety net” includes all legal regulations and autoregulations that aim to both preserve financial stability and protect the interests of the market participants that use the services of financial intermediaries. It also comprises all institutions that are responsible for the implementation of these standards into the practice (Iwanicz-Drozdowska, 2008, p. 23). In this way, she includes the protection of the interests of financial market customers within the scope of the safety net along with financial stability. Additionally she takes cross-border perspective and includes in the architecture of the safety net both public and private elements. To sum up our deliberations so far, it is fair to say that there is, as yet, no agreement among various researchers on the nature and scope of the financial safety net. There is no agreement either on its building blocks, even in terms of high-level principles. However, all these elements are undergoing substantial changes over time and some common understanding emerges. Initially the concept of the safety net was a narrowly defined banking-relevant construct. For this reason, its role in maintaining the stability of the financial system and combatting systemic risk has been underlined. With time, this strict limitation began to wane and the concept of the financial safety net came to cover the entire financial system. It also starts to be, expressis verbis, recognised in the academic literature not only as the tool for addressing macroeconomic and macroprudential concerns and assisting in the accomplishment microeconomic concerns. Thus, it reflects the growing convergence of the financial market and the growing interconnectedness of financial institutions. It also reflects our better understanding of the changes that have taken place in the financial system. Without going into unnecessary details we may therefore conclude that at the general level the financial safety net represents all devices, both public and private, which serve to protect the safety of financial markets and their customers. These devices include both private and public elements, both regulations and institutions. The safety net is a public construct and is shaped predominantly by the state. Private elements become a part of the safety net only once they are authorised or “accredited” by the state. Contemporary safety nets are focused primarily on the prudential protection of financial intermediaries and their customers, with little attention being given to financial products.

The aims of this protection may vary between different jurisdictions and market segments. In some (e.g. banks), macroeconomic and stability concerns prevail, in others (e.g. insurance), more microeconomic targets are tapped.

At the national level the net is an aggregate of the individual segments of the financial sector with various links and dependencies. At the international level it is an aggregate of national constructions and international layers.

Historically, safety nets are one of the main by-products of the Great Depression 1929–1933. Once mainly implicit and ad hoc they have now become by more and more explicit.

There are two sets of functions that can be allocated to the safety nets:

•preventive, which protects financial systems against financial shock;

•mitigating (crisis management), which aims to limit the costs of the failure of financial systems.

The complex nature of the contemporary nets requires a high level of coordination among various functions and institutions. This refers to national and even more to international contexts. The recent financial crisis has proved the inadequacy of the existing safety net arrangements. For these reasons, strong pressure exists to expand these arrangements into new areas and increase their protection level. This refers in particular to the ability of the public authorities to better identify, assess and mitigate emerging risks in the financial sector. Enhanced micro supervision, group-wide approaches, and prudent risk management are to be supplemented by macro supervision. Critical institutions and interconnectedness are to be better identified, reinforced and monitored. Finally, it should be mentioned that orderly resolution and limitations to the bailout role of the state are additional elements included in the amendments to the safety net.

3 Size and costs of the safety net

Maintenance of the safety net is not a cost-free exercise. The level of the costs involved depends primarily on the overall size of the net. It is however a complex methodological and practical challenge to evaluate its real size. This is well reflected in the fact that there are only a few empirical studies available so far on this issue. The two most interesting pieces of research were carried out in the US: in 2002, by Walter and Weinberg; and in 2010, by Malysheva and Walter (Walter and Weinberg, 2002, pp. 369–393; Malysheva and Walter, 2010, pp. 273–290). They used the same methodology and the same perimeter when referring to the size of the US federal government financial safety net. The federal financial safety net was straightforwardly defined as all explicit and implicit guarantees of the federal government with regard to the liabilities of the deposit-taking institutions, some GSEs (Government-sponsored Enterprises, such as Fannie Mae, Freddie Mac, Farm Credit System and Federal Home Loan Banks) and federally insured private-employer pension funds. Throughout these studies, government guarantees were understood as the commitments of the state to protect the creditors (lenders) from default-induced losses; explicit guarantees were understood as formal commitments of the federal government resulting from the existing laws, whereas implicit guarantees cover government commitments resulting from the past practice. According to the estimations of Walter and Weinberg, the overall size of the federal financial safety net in 1999 reached the level of USD 8.4 trillion and covered around 45% of the overall liabilities of the US financial...

Table of contents

• Cover
• Title
• Introduction
• Part I  General Issues
• Part II  Policy-Related Issues
• Part III  Global Issues
• Index