Financial regulators are worried that the credit risk banks do not want is effectively being transferred to the insurance, which potentially could have a destabilising effect on the global financial system.
Knut Hohlfeld, IAIS secretary general, said regulatory arbitrage is one of the key issues driving the ballooning credit risk transfer market, in which there are still some participants who are unused to using complex derivatives products such as collateralised debt obligations (CDOs).
Although Hohlfeld noted the benefits of credit risk transfer, he is wary that insurance companies are naively assuming credit risk in the search for replacement profits following declining equity returns.
“One thing that has come up in the study so far is the difficulty we encountered in gaining concrete data on credit derivatives transactions,” Hohlfeld told RiskNews. “There is a clear lack of standard reporting mechanisms for insurance companies active in the risk transfer arena, and this is worrying because there is an obvious appetite for new risk areas to increase yields.”
Hohlfeld also highlighted the importance of managing off-balance sheet investments. He added that the wider credit derivatives market poses a regulatory problem due to its sheer size and dramatic growth over the past five years. “We need more facts about what is going on and we just hope the wrong insurance and reinsurance players don’t get involved in areas they can’t understand.”
The UK’s Financial Services Authority (FSA) caused a storm in January when chairman Howard Davies quoted an unnamed investment banker as saying that synthetic CDOs were “the most toxic element of the financial markets today". In May, the FSA officially backed away from those comments. But, as the IAIS investigation indicates, the focus on the use of credit derivatives by insurance companies by national and international regulatory bodies looks likely to continue.
The IAIS will present its report at its annual conference held in Santiago, Chile, at the start of October. It will also deliver a copy of the report to the Financial Stability Forum, established in 1999 by the G7 to monitor financial markets.