The bosses of the world’s biggest insurers must feel as if regulators have grabbed them by the arms and are pulling them in opposite directions.
On one side are rule-makers concerned with protecting the global financial system from a repeat of the financial crisis. On the other are rule-makers with more local objectives: protecting policyholders from the insolvency of individual firms.
At times the interests of the two seem to be perfect opposites, with the use of derivatives a clear example. The ‘systemic’ group seems to want insurers to avoid a heavy use of derivatives, which it looks at with some suspicion. The ‘local’ group thinks derivatives can be a helpful tool to manage insurers’ risk and protect policyholders.
This is despite the regulators in the first group being the same as those in the second, just operating as part of the International Association of Insurance Supervisors (IAIS) and thinking about a different set of aims.
The proposition that both views could be right depends on seeing derivatives differently according to what they are being used for and by whom. When regulators think about systemic risk, they remember the experience of AIG during the crisis. From that point of view, derivatives can seem like a way for insurers to take risks they don’t understand and tie themselves to a wide group of counterparties as they do it. Regulators worry that a highly interconnected insurer might help transmit financial stress to other firms.
When regulators think about the solvency of individual insurers though, they focus on the ability of individual firms to manage risks. There, derivatives play an important role. Rules such as Europe’s incoming Solvency II directive are designed specifically to encourage firms to understand and hedge risks on their balance sheets, and have led to an increased use of derivatives by many.
Taking both views together, a large, widely-connected firm using derivatives to speculate with might constitute a systemic threat. But a smaller firm hedging risk with derivatives might not.
If only the distinction were that easy to make. What about derivatives for asset replication? Who determines how big is big? And when is a trade hedging and when speculation? More critically, what are the criteria for these decisions? Because without knowing the criteria, insurers can’t change what they do to make themselves less risky from either perspective. These are the questions G-Sii risk managers want answered.
Whether the IAIS will clear up the confusion when it finalises a consultation early next year remains to be seen. But speaking to Risk.net in November, Alberto Corinti, chair of financial stability for the association, was vague, talking of features and characteristics that might cause ‘systemic concern’ rather than hard and fast definitions of when derivatives might be acceptable or not.
Insurers say the problem would be solved if systemic rules were based on an economic view in the same way as regimes such as Solvency II. But perhaps that overlooks the point that systemic regulation has a different objective: to prevent contagion in a crisis rather than to prevent individual firms getting into trouble.
In practice, that means regulators seem unlikely to stop pulling on both arms, and equally unlikely to stop pulling in two different directions at once.