G-SII List Delayed

Risk Magazine is reporting that the initial list of global systemically important insurers (G-SIIs), originally due to be published in April 2013 by the Financial Stability Board (FSB) and the International Association of Insurance Supervisors (IAIS), has now been delayed until the end of Q2 2013.

Elsewhere, the FT is reporting that the IAIS is set to publish proposals on Wednesday which will mean the G-SIIs will not be subject to capital surcharges on their entire balance sheets, but only on that part of the balance sheet which constitutes non-traditional non-insurance business.  Moreover, insurers that take steps to segregate these businesses in separately capitalised entities will be subject to lower charges than those that allow co-mingling with other business lines to take place.

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Defining Systemic Importance for Insurers

On 12 February 2013, Julian Adams, FSA Director of Insurance, gave a speech at the Economist Insurance Summit in London on the lessons for insurance supervisors from the financial crisis.

Mr Adams explained that the overall objective of the FSA is to create an environment in which no insurer is too big, too complex or too interconnected to fail, and where participants are able to exit the market in an orderly fashion which ensures continuity of access to critical services.

He noted that the UK currently does not have a resolution regime for insurers, instead relying on ‘run-off’, Schemes of Arrangement and formal insolvency.  However, each of these options carries attendant risks meaning that it is necessary to at least consider whether a resolution regime for insurers in necessary.  Any such regime would be consistent with the Financial Stability Board’s ‘Key Attributes’ document and would also take a lead from the International Association of Insurance Supervisors, which is due to publish its initial list of Globally Systemic Important Insurers in the summer of 2013.  The key challenge is to recognise the specificities of insurance compared to other financial sectors – particularly the factors that make an insurer ‘systemically important’.  On this topic, Mr Adams highlighted three issues:

Use of Leverage – such as:

  • engaging in stock lending in order to invest proceeds in higher yielding (and therefore higher risk) paper; or
  • facilitating borrowing by non-insurance group members on the strength of an insurance business;

Asset Transformation – such as the sale of long-term investment products by life insurance companies; or

Assumption of Credit Risk – such as:

  • the securitisation of corporate paper; or
  • the funding of annuity liabilities through exposure to subordinated corporate debt.

If the answer to any one of these questions, alone or in combination, is positive then the FSA would “consider carefully” whether the firm in question was systemically significant.

Insurers Less Systemically Important Than Banks Says Geneva Association

Introduction

On 11 December 2012, the Geneva Association, a think-tank for the insurance industry, published a cross-industry analysis comparing the 28 Global Systemically Important Banks (G-SIBs) to 28 of the world’s largest insurers on indicators of systemic risk.

The analysis studied 17 indicators that are regarded as being comparable between insurers and banks to provide an analysis of the size of each activity. The conclusions drawn were that:

Insurers are significantly smaller than banks

  • The average bank’s assets are 3.9 times larger than the average insurer;
  • The largest insurer would rank only 22nd in the list of G-SIBSs by size.

Insurers write considerably less CDS than banks

  • The average bank writes 158 times the value of gross notional Credit Default Swaps (CDS) than the average insurer;
  • The lowest ranked banks on average have 12.5 times the CDS sold by the average insurer.

Insurers utilise substantially less short-term funding than banks

  • Short-term funding as a percentage of total banks assets is 6.5 times higher than short-term funding as a percentage of insurer assets.

Insurers are less interconnected to other financial services providers than banks

  • Banks carry 219 times more gross derivative exposure than the insurer average;
  • The lowest ranked banks carrying 66 times more gross derivative exposure than the average insurer;
  • At the measurement date, banks owed on average 68 times more than insurers in gross negative derivatives;
  • Banks are owed 70 times more from derivatives counterparties through derivatives exposure than insurers.

 

IAIS consults on policy measures for global systemically important insurers

Introduction

On 17 October 2012, the International Association of Insurance Supervisors (IAIS) published a consultation document relating to proposed policy measures for global systemically important insurers (G-SIIs) i.e. insurers whose distress or disorderly failure would cause significant disruption to the global financial system.

The consultation remains open until 16 December 2012 and details policy measures designed to reduce the probability and impact of G-SII failure as well as to incentivise G-SIIs to become less systemically important and non G-SIIs not to become G-SIIs.  The policy measures are broken down into three main categories:

  • Enhanced supervision;
  • Effective resolution; and
  • Higher loss absorption (“HLA”) capacity.

Enhanced Supervision

Non-traditional and non-insurance (NTNI) activities of G-SIIs, such as derivates trading, are regarded as particular sources of systemic risk.  Within most G-SIIs, NTNI activities are carried out within separate group companies.  As such, it is necessary for supervisors of G-SIIs to have group-wide supervision powers.  Within this context, enhanced supervision will take the form of:

  • Enhanced liquidity planning and management; and
  • Systemic Risk Reduction Plans.

Enhanced Liquidity Planning and Management

G-SIIs will be required to have adequate arrangements in place to manage group liquidity risk, primarily in relation to NTNI activities and channels of interconnectedness.

Systemic Risk Reduction Plan

In addition to maintaining recovery and resolution plans (RRPs), G-SIIs will be required to develop Systemic Risk Reduction Plans (SRRP).  The purpose of an SRRP is to shield traditional insurance business from NTNI business (and vice versa), reduce the systemic importance of the G-SII and improve resolvability.  Where appropriate, an SRRP should include ex-ante measures to ensure the effective separation of systemically important NTNI activities from traditional insurance business into standalone, regulated entities.  GSIIs must ensure that any entities created as a result of this process do not benefit from subsidies in the form of capital and/or funding and are:

  • Structurally self-sufficient: meaning that the entity could be liquidated without impacting the remaining group and that intra-group transactions such as guarantees  and cross-default clauses are either prohibited or at a minimum adequately monitored and restricted; and
  • Financially self-sufficient: meaning that the entities in question are adequately capitalised.

 In addition, the following specific policy measures should be considered:

  • Direct prohibition or limitation of systemically important activities;
  • Requirements for prior approval of transactions that fund or support systemically important activities;
  • Requirements for spreading or dispersing risks relating to systemically important activities; and
  • Limiting or restricting diversification benefits between traditional insurance business and other businesses.

 Effective resolution

The FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” (Key Attributes) details the specific resolution requirements for all G-SIFIs and forms the basis for improving G-SII resolvability.  These requirements include:

  • The establishment of Crisis Management Groups (CMGs);
  • The elaboration of recovery and resolution plans (RRPs);
  • The conduct of resolvability assessments; and
  • The adoption of institution-specific cross-border cooperation agreements.

However, measures to resolve G-SIIs must also account of the specificities of insurance including:

  • Measures needed to separate NTNI activities from traditional insurance activities;
  • The possible use of portfolio transfers and run off arrangements as part of the resolution of entities conducting traditional insurance activities; and
  • The existence of policyholder protection and guarantee schemes (or similar arrangements).

Higher loss absorption (HLA) capacity

The IAIS proposes a cascading approach to increasing HLA capacity.  Initially, higher HLA requirements would be targeted on specific G-SII group entities depending on the extent to which it had demonstrated effective separation between traditional insurance and NTNI activities, with additional capital being required in relation to activities that have the potential to generate or aggravate systemic risk (e.g. NTNI businesses).  Subsequently, an assessment of the adequacy of group HLA levels would also be performed.  This would take into account the level of HLA in individual group companies and any entity separation that exists, but only where that HLA was not created by multiple-gearing through down streaming capital within the G-SII.  However, the IAIS acknowledges that there is an on-going internal discussion as to whether this subsequent step is required if targeted HLA and other measures (such as restrictions and prohibitions) are effective in reducing systemic importance to an acceptable level.  In all cases, higher HLA capacity could only be met by “the highest quality capital”, being permanent capital that is fully available to cover losses of the insurer at all times on a going-concern basis.

Implementation time frame

A detailed timeline for the implementation of G-SII policy measures is detailed below:

Key Implementation Dates and Timeframes

Action Required

 

April 2013

First G-SIIs designated (with annual designations thereafter   expected each November)

From 2013

Implementation of enhanced supervision and effective resolution   commences

End 2013

IAIS   to elaborate proposed HLA capacity measures

Within 12 months of designation

Crisis   Management Groups (CMGs) to be established

Within 18 months of designation

Other   resolution measures to be completed

Within 18 months of designation

Systemic   Risk Reduction Plan (SRRP) to be completed

Within 36 months of designation

Implementation of SRRP to be assessed

November 2014 to 2016

G-SIIs   designated annually (with HLA not applicable until 2019)

November 2017

G-SIIs   designated based on 2016 data (with HLA applicable from 2019)

January 2019

HLA   capacity requirements apply based on assessment of implementation of the   structural measures

 

HM Treasury Publishes Summary of Responses to Consultation on Non-bank resolution

Introduction

On 17 October 2012, HM Treasury published a summary of responses received to its August 2012 consultation paper, entitled “Financial Section Resolution: Broadening the Regime” (the “Consultation Paper”).  Broadly, the Consultation Paper had proposed the widening of resolution regimes to systemically important non-banks, specifically:

  • Investment firms and parent undertakings;
  • Central counterparties (CCPs);
  • Non-CCP financial market infrastructures (non-CCP FMIs); and
  • Insurers.

For a full summary of the Consultation Paper, please see our previous blogpost “HM Treasury Consultation:  RRP for Financial Market Infrastructures” dated 8 August 2012.

Summary of Responses

HM Treasury received 45 responses to the Consultation Paper prior to the 24 September 2012 deadline.  Broadly, respondents were supportive of the original position of the Government, which reconfirmed its intention to develop the UK regime in advance of European legislation.  The main changes to be implemented in light of the Consultation Paper are set out below.

Investment firms and parent undertakings

The Government proposes:

  • to narrow the definition of investment firms which are subject to the resolution regime proposals so as to promote consistency with the Recovery and Resolution Directive by excluding small investment firms that are not subject to an initial capital requirement of €730,000; and
  • an extension of stabilisation powers to group companies in order to facilitate resolution, but subject to certain conditions, such as limiting such powers to financial groups (rather than financial elements of any group that contains a bank, as was proposed in the Consultation Paper).

Central Counterparties

The Government proposes to include an additional objective for intervention in a failing CCP, which seeks to maintain the continuity of critical services.  It notes the mixed response from the industry regarding the intervention power generally but continues to regard this as justified given the systemic consequences which closure of a CCP’s critical functions could have, particularly where there are no obvious substitutes for the CCP.  However, the Government also accepts that recognised clearing houses that do not provide central counterparty clearing services should be excluded from the regime altogether, meaning that they are likely to be covered by proposals relating to non-CCP FMIs.

The Government also noted the strong industry opposition to its proposal to allow resolution authorities to impose on the clearing members of a CCP any losses which were above and beyond those dealt with by the CCP’s existing loss allocation provisions.  It was felt that this proposal would cause uncertainty, could potentially lead to distorted incentives such as the early termination and exit of members, might put UK CCPs at a competitive disadvantage and could have capital and liquidity implications for clearing members.  In light of this, the Government has decided not to pursue the proposal, but remains of the view that taxpayers should not be expected to meet the cost of restoring a failed CCP.  As such, it proposes to make loss allocation rules mandatory for the purposes of authorisation as a Recognised Clearing House within the UK and will re-consult on this new proposal in due course.

Non-CCP FMIs and Insurers

The government accepts that the case for a full resolution regime for Non-CCP FMIs or insurers is less clear cut.  Most Non-CCP FMIs have no financial exposure, similar to those faced by CCPs, and any failure is more likely to be operational or technological in nature.  In addition, there seems to be a general recognition that traditional insurance activities – whether general or life insurance business – do not generate or amplify systemic risk.  In contrast, non-traditional insurance and non-insurance activities (such as derivative trading) are regarded as sources of systemic risk.

It seems that the Government accepts that a strengthening of the existing regimes appears to be the most appropriate option and will engage in further dialogue to determine how best this can be achieved.

Next Steps

The changes to proposals regarding investment firms and their parent undertakings, deposit taking institutions and CCPs will be effected by changes to the Financial Services Bill that is currently before Parliament.  For non-CCP FMIs and insurers, the government will take further time to consider the arguments presents by respondents to the Consultation Document and decide the best way to proceed.

Living Wills to be a Condition of Authorisation?

This FT article reports on a speech given yesterday in Edinburgh by Andrew Bailey, director of banks and building societies at the FSA.  According to the report, any new entrant to the banking or insurance sectors will be required to produce a credible Living Will as a pre-condition to authorisation.

Concerns have been raised that this will further stifle competition, particularly in the banking sector.  However, the principle of requiring new entrants to consider issues relating to their ultimate resolvability from day one and factor any conclusions into initial business structures, seems an eminently sensible one.

Recovery and Resolution Plans for Globally Systemically Important Insurers by Mid-2014

Introduction

On 31 May 2012 The International Association of Insurance Supervisors (the “IAIS”) published a consultation paper (endorsed by the FSB) concerning its proposed assessment methodology for the identification of globally systemically important insurers (“G-SIIs”), being any insurer “whose distress or disorderly failure, because of their size, complexity and interconnectedness, would cause significant disruption to the global financial system and economic activity”.

The Assessment Methodology

The assessment methodology is based broadly on that used to identify globally systemically important banks (“G-SIBs”) but tailored to the insurance industry.  In developing the methodology, the IAIS took account of the apparent absence of evidence to suggest that traditional insurance business either generates or amplifies systemic risk.  Accordingly, in determining whether an insurer is a G-SII, more emphasis is placed on those insurers who participate in non-traditional and non-insurance activities, such as derivatives.

The proposed assessment methodology involves three steps:

  • Collection of data;
  • Methodical assessment; and
  • Supervisory judgment and validation.

Collection of data

To ensure the quality and relevance of underlying data, the IAIS based is assessment on data requested from 48 of the largest insurance groups active across 13 jurisdictions as of year-end 2010.

Methodical Assessment

The IAIS proposes to measure ‘systemic importance’ in terms of the impact that distress or failure of an insurer might have on the global financial system and the wider economy rather than in terms of the probability of a failure of the insurer in question.  An indicator-based approach based on the five categories listed below is proposed.  This will provide a first indication of the relative importance of each insurer under consideration.  Within each category are a number of indicators the purpose of which is to capture the degree and nature of each insurer’s systemic importance.

Category

Indicator 

Size

Total assets

Total revenues

Global Activity 

Revenues derived outside of home country

Number of countries

Interconnectedness 

Intra-financial assets

Intra-financial liabilities

Reinsurance

Derivatives

Large exposures

Turnover

Level 3 Assets (i.e. assets the fair value of which cannot be   determined by using observable measures)

Non-traditional   and Non-insurance Activities 

Non-policy holder liabilities   and non-insurance revenues

Derivatives trading (notional CDS protection sold)

Short-term funding

Financial guarantees

Variable annuities

Intra-group commitments

Substitutability

Premiums for specific business lines

In addition, it seems likely that the final methodology will incorporate additional factors, such as:

  • The amount (in economic terms) of derivatives trading without hedging purposes; and
  • The liquidity of insurance liabilities.

Relevant Importance of each Category

The two most important categories for assessing the systemic importance of insurers are:

  • Non-traditional insurance and non-insurance activities – because the longer timeframe over which insurance liabilities can normally be managed (which is considered to be a mitigating factor in assessing systemic risk) may not be present; and
  • Interconnectedness – because of the strong connections between the insurance and banking sectors.

Calculating Systemic Importance

The Assessment Methodology will be used to calculate a systemic importance ranking of all of the 48 insurance companies under consideration.  The overall score for a particular insurer is calculated as the sum of all of the weighted category scores for that insurer.  In turn, each category score is calculated as the amount that the insurer in question represents with respect to that category as a proportion of the entire sample for the category in question, after weightings are applied.  Within a category, all indicators are given an equal weighting.  As a result, category weightings are very important to the calculation.  The weightings assigned to each category are:

Category

Weighting

Non-traditional insurance and non-insurance activities

40%-50%

Interconnectedness

30%-40%

Size

5%-10%

Global Activity

5%-10%

Substitutability

5%-10%

At this point a number of methodologies will be employed in order to determine the cut-off point between G-SIIs and non-G-SIIs, one being a comparison of publicly available data which is common to all of the insurers under consideration as well as G-SIBs.

Supervisory Judgment and Validation

The Supervisory judgment and validation stage introduces both a qualitative as well as an quantitative assessment, in recognition of the fact that no single methodology can perfectly measure systemic importance across all global financial institutions.  Additional analysis will be conducted in order to validate the results of the indicator-based approach conducted under the “Methodical Assessment” section.  This analysis (the “IFS Assessment”) divides the business portfolio of an insurer into:

  • Traditional insurance;
  • Semi-traditional insurance;
  • Non-traditional insurance;
  • Non-insurance financial; and
  • Industrial activities.

Again, risk weightings are used to calculate systemic importance, the highest ratings being allocated to the “Non-insurance financial” and “Non-traditional insurance” categories.  The findings are then compared to the results from the indicator-based approach to provide a check on their reasonableness and to assist informed discussions with relevant group-wide supervisors.  Based on these assessments and discussions, the IAIS will determine if additional analysis is required, or whether an insurer should be added to the list of G-SII candidates.  Once a candidate list is finalised, the IAIS will make recommendations as to which insurers should be regarded as G-SIIs to the FSB, who will ultimately make the decision.

Policy Measures for G-SIIs

The IAIS will develop policy measures to be applied to G-SIIs, which will be the subject of a separate consultation exercise later on this year.  The measures are likely to include:

  • More intensive and co-ordinated supervision of SIFIs;
  • A requirement to develop Recovery and Resolution Plans on the basis set out in the FSB’s “Key Attributes for Effective Resolution Regimes”; and
  • Higher loss absorbency for SIFIs to reflect the greater risks that these institutions pose to the global financial system.

Timeline

An initial list of G-SIIs is expected from the FSB in the first half of 2013 and a revised list of G-SIIs is to be published in November every year.  The IAIS expects that the G-SII measures would be applied with an 18 month time lag compared to those for G-SIBs due to the different overall timetable concerning the G-SIFI insurance project.  This would mean that Recovery and Resolution Plans would be expected to be in place by mid-2014 for G-SIIs compared with the end of 2012 for G-SIBs.

The IAIS consultation paper is open for comment until 31 July 2012.  The consultation paper, press release and FAQ document are all available here:

http://www.iaisweb.org/Consultations-918