Role of Insurance in Global Financial Stability - Assignment Example

Running Head: INSURANCE AND RISK MANAGEMENT Role of Insurance in Global Financial Stability (Name) (Course) (University) Date of presentation: Lecturer: Role of Insurance in Global Financial Stability Introduction The global financial crisis which began in 2007 greatly accelerated and affected many countries and companies. The crisis posed unique challenges for financial market regulators, especially insurance companies about how financial risks should be mitigated and what financial policies should be put in place to stabilize financial systems. In the United States, the severity of the events which transpired during and after the crisis has been a shock to the country’s political and financial system. The crisis brought to the forefront the issue of what insurance companies should do to stabilize impaired financial institutions (Eling & Schmeiser, 2010). While the financial crisis may have been primarily a banking crisis, but the solvency of the global insurance sector and the entire financial sector in general was severely threatened. In particular, insurance companies were affected in several diverse ways, primarily because of their heavy investments in portfolios. As a result, different views have been expressed regarding the role of the insurance sector in stabilizing the global financial system. One of these views is that the insurance sector can stabilize the financial systems by absorbing systematic risks that pose major threats to banking institutions. While the insurance sector was not the origin of the financial crisis and did not repackage any of the subprime mortgages that led to the crisis, the insurers were major financiers of the mortgage-based financial instruments. As such, the insurance sector was at a position to rekindle market volatility through its capacity as a long-term investor. In this way, the insurance sector can act as a stabilizing sector in the financial market during moments of stress. This research paper reviews vulnerabilities in the global financial system and what role the insurance sector can play to suppress the impact of these vulnerabilities. Role of Insurance Companies as Shock Absorbers during Financial Crisis Traditionally, the primary role of the insurance sector is to give indemnity to individual and corporate policyholders. The indemnity is usually given to claims resulting from adverse events, but the insurers can also give provide a stable means of long-term savings for the policyholders. To guarantee indemnity and savings, insurance companies have to rely on diversification of risks. Risk diversification is effected by pooling of different policyholders risks and by diversifying across different kinds of risks (Eling & Schmeiser, 2010). Nevertheless, some risks remain after diversification and these require other mitigation techniques such as hedging, reinsurance and use of insurance linked securities. In general, insurance companies incorporate several risk management practices such as asset-liability management practices to offset asset-liability mismatches. Moreover, a variety of supervisory practices and regulatory frameworks are engaged to maintain high solvency levels in the insurance industry. In some countries, the actuarial profession is engaged by insurance companies to manage risks. Some countries have even enacted statutory requirements for insurance companies to obtain appropriate actuarial services in their business operations. Despite these sophisticated risk management practices, insurance companies occasionally become distressed financially and in the modern financial markets where competition is very high, financial distresses and insolvency can occur quite often. Fortunately, the financial distresses of the insurance companies can last for a considerably long time (Eling & Schmeiser, 2010). This is because the insurer’s assets do not usually get liquidated until benefits under policies are paid. As such, insurance regulators have time to intervene to check the potential losses arising from insolvency, although this might not always be the case since different distresses are caused by different factors and impact differently. Debates about the actual causes of financial crises are ongoing, but there is general agreement that a combination of several factors plays a role and not just a single factor. According to Acerbi (2002), the fundamental changes that have occurred in financial in the past few decades constitute a significant causal factor. For instance, prior to the 2007 financial crisis, most banks in the United States had a tendency of distributing risks instead of withholding loans on their own balance sheets till maturity. This move permitted the spread of risk from the banking institution’s balance sheets to the portfolios of other entities most of which were more willing to bear the additional risks. The result of this process was a sharp rise in the level of indebtedness in several sectors of the economy, especially the housing sector where the risks proved unbearable. One consideration which is often overlooked in such contexts is that the ability of banking institutions to manage risks depends on the availability of credit transfer instruments, as well as, the willingness of investors to add these risk instruments to their portfolios (Acerbi, 2002). Insurance companies, which are undeniably one of the largest investors in the international financial systems, have been more than willing to add credit risks to their portfolios like other investors. Other insurance companies have gone as far as providing enhancements which make credit instruments to look attractive to investors. In their article, Kočović Tatjana & Marija (2011) have explained that insurance companies and banking institutions share common market characteristics and risks because of their involvement as financial intermediaries. However, the roles of the two institutions in an economy differ significantly: banks are merely part of the settlement and payment system and are mostly concerned with the onward transmission of monetary policies. To a larger extent, banks rely more on short-term borrowing and are, therefore, exposed to liquidity risks. Insurance companies, on the other hand, accept premium payments in advance and hence are not affected by liquidity risks. Nevertheless, insurance companies can be affected by liquidity risks if they allow large borrowings to finance rapid organic growth or acquisitions. In his analysis of the role of the insurance sector in mitigating financial risks, (Acerbi, 2002) has underscored the important consideration that insurance companies are susceptible to risks generated by other players in the financial system such as banks and mortgage financiers. In fact, there is little evidence of the insurance sector generating systematic risks in the real economy or within the financial market alone. This is largely because of the fundamental differences in the roles of banks and insurance companies in an economy. In essence, insurance companies play stabilization roles, and this helps limit systematic risks. The stabilization role of the insurance sector has all along been the chief focus of financial experts especially after the 2007-2010 global financial crises. Both the insurance and reinsurance activities are crucial services that help distribute risks in the financial system although these activities can at times cause interconnectedness in a financial system. Acerbi (2002) has observed that failure by a large insurance company or a reinsurer can have a significant impact on the capacity of the insured to mitigate their liquidity risks. Such a failure can quickly spiral into the entire financial system and cause real disruptions to an economy. Essentially, insurance companies are interconnected to other players in financial systems through corporate debt holdings; equity shareholdings; treasury operations; security lending and other forms of investment. Whether these interconnections are crucial to the occurrence of systemic risks depends on the extent to which the investments by insurance companies contribute to an economy (Martin, Barnett & Coble. 2001). As indicated by Pottier & Sommer, (2002) lack of substantiality in investments by insurance companies can easily lead to market disruptions in financial systems, especially when insurance coverage is essential for the business. As an example, market disruptions can occur when widely used insurance products become unavailable. Moreover, insurance against catastrophic events may become available or costly in case the catastrophic event occurs. There are also possibilities that insurance capability reduces in certain market segments such that the real economy gets disrupted. The insurance sector tends to have a wide array of diversified investment portfolios. Moreover, this sector focuses on high quality investments and is mostly well protected against financial market risks (Eling & Schmeiser, 2010). However, insurance companies become more affected as turbulences in the financial system develop into full-blown crises in which even high-grade securities and investments get affected. At this point, it becomes clear that losses on financial assets have spread well into the insurance universe. In certain insurance sectors, there are underwriting exposures and direct connections to origins of financial crises. Because of this, insurance companies have increasingly become active in utilizing a wide range of mitigation techniques to hedge their own credit risks and market risks (Schich, 2008). The past few years have witnessed a stead rise in the trading of insurance linked instruments such securities for life insurance reserves, property catastrophe bonds and insurance risk swaps. These instruments give financial professional and risk managers the ability and means to identify, monitor and control financial risks. An analysis by Trainar (2008) has effectively captured the important role of insurance companies in financial risk management and market stabilization. In their article, Eling and Schmeiser (2010) have noted that financial risk management is the central activity of all financial intermediaries including insurance companies. The intermediaries absorb risks from the financial system by investing their assets in information sensitive and illiquid instruments. This creates imperfections in financial systems, which allows the intermediaries to make profits. However, the imperfections can also cause costs and the intermediaries must finance themselves by issuing illiquid and information-sensitive claims. This illustration implies that exogenous shocks to the insurance companies’ financial systems can have implications for the pricing of instruments in which they seek to make investments (Kočović, Tatjana & Marija, 2011). Financing of financial market imperfections influences a number of financial policies including capital budgeting and risk management. In order for insurance companies to reduce capital risks and conserve their internal funds, they should hedge out all market risks. From the market perspective, hedged securities have a net present value of zero because they are done at fair prices. They, however, create additional market values because they allow the market to use less capital or raise needed capital every so often (Glasserman & Li, 2005). The services of insurance companies enable players in financial markets to structure capital budgeting policies by raising the minimum credibility requirements and hurdle rates. Increases in internal hurdle rates can be effective in controlling internal funds. After all, financial service firms are more likely to reduce investments in new securities than they are likely to reduce the assets in place. In this regard, financial firms maintain large and healthy balance sheets, which encourage substantial reductions in risk exposure (Trainar, 2008). For insurance companies, it might not be an optimal risk management measure to raise hurdle rates only. Insurance companies usually consider investments, which correlate positively with fluctuations in firm capital and these investments receive higher hurdle rates. However, those investments, which correlate negatively with a firms’ internal capital receive low hurdle rates. Trainar (2008) has critiqued that in the absence of financing perfections, optimal hurdle rates should factor in additional factors driven by correlation with a firm’s internal capital. That is why insurance companies measure the value of capital at risk by the degree of risk aversion. This helps reflect the shadow values of a firm’s internal funds. According to (Glasserman & Li, 2005), where financial imperfections are present, financial companies encourage active use of hedging and increased hurdle rates to absorb shocks to the financial system. Conclusion Instabilities in financial systems can be devastating. Insurance companies, as risk-takers need to have a reliable source of information about risks inherent in a financial system so that appropriate remedial measures can be designed. In particular, insurance companies play a very important role in stabilizing financial markets. They not only provide insurance coverage for other players in the financial service industry, but also accept risks from the other players by buying debt securities and by investing in extremely volatile portfolios. It is imperative that insurance companies work closely with other players such as banks and mortgage lenders to identify, monitor and mitigate financial market risks. While insurance companies cannot hedge out all risks inherent in a financial system, they can to a great extent help mitigate the impact of systemic risks. References Acerbi, C 2002, “Spectral measures of risk: a coherent representation of subjective risk aversion”, Journal of Banking Finance, vol. 26, no. 7, pp. 1505–1518. Eling, M & Schmeiser, H 2010, “Insurance and the Credit Crisis: Impact and Ten Consequences for Risk Management and Supervision”, The Geneva Papers on Risk and Insurance - Issues and Practice, vol. 35, no. 1, 2010. p. 9-34. Glasserman, P & Li, J 2005, “Importance sampling for portfolio credit risk”, Management Science. Vol. 51, pp. 1643–1656. Kočović, J., Tatjana, R. and Marija, J 2011, “The Impact of the Global Financial Crisis on the Structure of Investment Portfolios of Insurance Companies”, Economic Annals, Vol. LVI, No. 191 / October – December 2011. Martin, S., Barnett, S and Coble, H 2001, “Developing and Pricing Precipitation Insurance,” Journal of Agricultural and Resource Economics, vol. 26, no. 1, pp. 261-274. Pottier, S. and Sommer, D 2002, “The Effectiveness of Public and Private Sector Summary Risk Measures in Predicting Insurer Insolvencies”, Journal of Financial Services Research, Vol. 21, no. 1, pp. 101–116. Schich, S 2008, “Challenges related to Financial Guarantee Insurance”, OECD Financial Market Trends, Vol. 1, pp. 81-113. Trainar, P. 2008, “Valuation in insurance and financial crisis”, Financial Stability Review, No. 12, pp. 68-103. Read More