A report from the Geneva Association, “Reflections on a High-Quality G-SIFI Designation Process in Insurance,” authored by Daniel Haefeli and Patrick M. Liedtke, gives some meaningful insights into the process of defining what is – and is not – a G-SIFI (globally systemic important financial institution).

The paper notes that as a result of the financial crisis, “the G-20 commissioned the Financial Stability Board (FSB) to develop a process to designate globally systemic important financial institutions. The FSB enlisted the International Monetary Fund (IMF) and the Bank for International Settlement (BIS) in the process, and has published its “Guidance to Assess Systemic Importance of Financial Institutions, Markets and Instruments.” It has also begun work on “establishing key criteria for the identification of systemic risk.”

While the original demand overwhelmingly targeted banks, the authors note that somewhere along the line it became clear “that the insurance industry, despite the resilience it had displayed throughout the crisis, would be swept up in the rearrangement of the global financial architecture and the measures to be introduced.”

The industry was given an extension – of sorts – in that only 29 banks – no insurers – were on a list published during the G-20 meeting of November 2011. Insurers were put on a “longer timeline.” The authors note that it’s expected, “after the approval of the International Association of Insurance Supervisors (IAIS) methodology in the second half of 2012, the FSB will finalize its designation process for insurers with support from the IAIS. The result is expected this coming November when the new G-SIFI list will be released.”

Since the early stages of the financial crisis, The Geneva Association has been contributing regularly to the debate on financial stability and, in particular, on how to deal with G-SIFI issues adversely affecting the insurance sector.

This research led to the “development of an activity-based approach consisting of three phases,” identified as:  
1) Identification of potentially systemic risky activities (pSRAs);
2) The designation of companies engaged in these pSRAs who do not possess enough mitigating factors to be G-SIFIs (including a proper resolution framework that would protect the financial system); and
3) The definition of consequences and policy measures for designated G-SIFIs that are targeted on the sources of systemic risk and commensurate with the potential risk exposure.

In its March 2010 report “Systemic Risk in Insurance—an analysis of insurance and financial stability,” the Association identified and analyzed “activities that might create systemic risk under certain circumstances.” The main findings unsurprisingly concluded that “core insurance business does not cause systemic risk but only some particular ‘banking-like’ activities, such as writing derivatives [See AIG] and the mis-management of short-term funding, have the potential to create systemic risk that impacts the global finance industry and the wider economy.”

The finding has created somewhat of a dilemma. It logically follows that insurers who don’t dabble in derivatives or short term funding or similar risky financial transactions don’t pose a systemic risk to the global economy, and therefore “must not be included in any designation process, as no systemic risk can emerge from them.”

Segregating those insurers that could pose a risk from those that don’t, however, is not an easy task, hence the current paper on how “to develop a better understanding of the key aspects that an appropriate designation process in insurance should exhibit.” Once that’s completed the next step is to set out how they will be applied in determining who could be given a G-SIFI designation.

The authors point out that as “systemic risk” is a relatively new and not completely explored concept, the “G-SIFI designation process has to be grounded in a solid understanding of the fundamentals of the insurance business and the individual companies.”

In addition “the process of G-SIFI designation for insurance must itself be clearly explained and the benefits that the economic system would derive from such a designation should be clarified; in particular, it should describe how policyholders would be affected.”

 The paper adds: “G-SIFI status should only be given to companies that are in a position to generate systemic risk in case of failure, i.e. companies that pose a threat to the global financial system. This means that the G-SIFI status and its consequences have to provide the right macro-economic balance between, on the one hand, additional cost (cost of capital, costs for enhanced supervision, costs for special measures, etc.), which might be borne by policyholders via higher premiums or by the shareholders via reduced profits, and the benefits of a more stable financial system, on the other.”

The authors warn that “burdening inherently stable activities such as those of core insurance with additional costs does not provide additional benefits for the economy since these activities are not a source of systemic risk. It would also be a distortion of the free market if G-SIFI status provided a company with a competitive advantage such as governmental guarantee or the misguided public perception of the company as a player benefiting from a special rescue option without necessarily incurring additional costs.”

This squares the circle back to the initial proposition that a “G-SIFI designation can thus only depend on and be justified by the company’s significant engagement in potentially risky activities as defined above. In order to achieve a level playing field within the whole financial services industry, the role of an insurer conducting pSRAs has to be compared with that of all players of the financial services industry using the criteria established by the FSB and the IAIS, namely size, interconnectedness and substitutability.” 

The paper goes on to outline some of the more important criteria that should be considered as basic to any designation. They are set forth at length in the report, and summarized as follows:
– Business decisions are planned ahead and must be able to rely on a stable and predictable process. A transparent designation process with clear criteria and indicators will help the management of a company engaged in pSRAs to appreciate its own potential to be considered a G-SIFI and how a change in circumstances might affect that status.
– Not only is transparency key to the process, reliability also is a fundamental requirement. A G-SIFI must be designated based on globally consistent and reliable rules that are applied irrespective of its domicile.
– As much as the process has to be transparent, predictable and reliable, we believe that it also needs to allow interaction between companies and supervisors (solo and/or group supervisor) during the designation phase. Assessing systemic risk potential is very complex and requires an in-depth analysis of the ways in which systemically risky activities are carried out and how they are woven into existing supervisory process.
– The global SIFI debate has, so far, mainly focused on the banking world. It reflects the common consensus that, to date, systemic risk has always been created by banking activities. With the inclusion of insurance into this debate, it is of utmost importance thatadequate insurance know-how is incorporated within the rules-setting bodies on all levels.

In conclusion the authors wrote: “Any G-SIFI designation process should be of the highest possible quality and be transparent, predictable and reliable. Regulators should explain why and how any potential designation will provide additional protection for the financial system and what the cost to regulators, supervisors, insurance companies, policyholders and the financial market might be of any such designation. The Geneva Association and the insurance industry stand ready to support the design of the designation process with additional analytical input.” 

Source: The Geneva Association