First Nine G-SIIs Named

Introduction

On 18 July 2013, the Financial Stability Board (FSB) published a press release endorsing the assessment methodology and policy measures published by the International Association of Insurance Supervisors (IAIS) discussed below, and naming the first nine globally systemically important Insurers (G-SIIs).  The list will be published each November, starting in 2014 and initially comprises:

• Allianz SE;
• American International Group, Inc.;
• Assicurazioni Generali S.p.A.;
• Aviva plc;
• Axa S.A.;
• MetLife, Inc.;
• Ping An Insurance (Group) Company of China, Ltd.;
• Prudential Financial, Inc.; and
• Prudential plc.

On the same date the IAIS announced that it had published:

• a G-SII Initial Assessment Methodology;
• G-SII specific policy measures, and
• an overall G-SII framework for macroprudential policy and surveillance.

G-SII Initial Assessment Methodology

The methodology (which has already been criticised as being “opaque and arbitrary” on account of the fact that it contains no quantitative cut-off point for G-SII designation, preventing firms from knowing what actions would help them remain below the G-SII threshold) is designed to assess the systemic importance of insurers, using year-end 2011 data collected from selected insurers in 2012 and employing a three-step process involving:

• the collection of data;
• a methodical assessment based on five weighted categories and 20 indicators;
  • non-traditional insurance and non-insurance (NTNI) activities (45% weighting);
  • interconnectedness (40% weighting);
  • substitutability (5% weighting);
  • size (5% weighting); and
  • global activity (5% weighting); and
  • a supervisory judgment and validation process.

G-SII Policy Measures

The IAIS policy framework for G-SIIs is three-pronged, consisting of:

Enhanced Supervision

These measures entail the development of Systemic Risk Management Plans, enhanced liquidity planning and management and the granting of direct powers over holding companies to group-wide supervisors.  There is also a reasonably detailed discussion of:

• the nature of traditional insurance versus NTNI activities; and
• effective separation of NTNI business.

Traditional versus NTNI Insurance

Traditional Insurance is broadly characterised by insured events which are accidental in nature, random in occurrence and subject to the law of large numbers.  In contrast, NTNI broadly includes activities that are more financially complex than traditional insurance, where liabilities are significantly correlated with financial market outcomes (such as stock prices, and the economic business cycle) and have financial features such as leverage, liquidity or maturity transformation, imperfect transfer of credit risks, (i.e.“shadow banking”), credit guarantees or minimum financial guarantees.

Effective separation of NTNI

Whether NTNI activities are effectively separated goes to the heart of G-SII resolvability and the amount of Higher Loss Absorption (HLA) to be applied to a G-SII. The following conditions are relevant in this determination:

• Self-sufficiency: an effectively separated entity will be able to operate without the support of parent or affiliates;
• Operational independence of management;
• Regulated status: the effective separation of NTNI activities must not result in a non-regulated financial entity;
• Arm’s length dealings: any intragroup transactions or commitments with the separated NTNI entities must be executed “at arm’s length”; and
• Reputation risk: the risk that a parent or affiliate provides financial support to an entity even though there is no legal obligation to do so must be limited.

Effective Resolution

The IAIS’s proposals for the effective resolution of G-SIIs are based on the FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions but takes account of the specificities of insurance.  This entails the establishment of Crisis Management Groups, the development of recovery and resolution plans (RRPs), the conduct of resolvability assessments, and the adoption of institution-specific cross-border cooperation agreements.

Higher Loss Absorption Capacity

G-SIIs will be required to have HLA capacity.  This may only be met by “highest quality capital”, being permanent capital that is fully available to cover losses of the insurer at all times on a going-concern and a wind-up basis.  In applying this requirement a distinction may be made based upon whether a firm’s NTNI activities have been effectively separated from traditional insurance business.  HLA may be targeted at the entities where systemically important actives are located and also take account of whether group supervisors have authority over any non-regulated financial subsidiaries.

Report on Macroprudential Policy and Surveillance in Insurance

In addition to the microprudential supervision measures constituting the G-SII Policy Measures, the IAIS also released a framework for implementing macroprudential policy and surveillance (MPS) in the insurance sector, designed to maintain financial stability. Its focus is on enhancing the supervisory capacity to identify, assess and mitigate macro-financial vulnerabilities that could lead to severe and wide-spread financial risk.  Over time, the MPS framework will be refined through the issuance of guidance on the practical application of IAIS Insurance Core Principles, and the development of a toolkit and data template regarding early warning risk measures.

Implementation Timeframe

Key implementation dates are as detailed below:

Event	Date
Implementation   of enhanced supervision for G-SIIs	Immediate
FSB to designate the initial   cohort of G-SIIs based on the IAIS methodology	July 2013
For   designated G-SIIs, implementation commences of resolution planning and   resolvability assessment requirements	July 2013
IAIS   to prepare a workplan to develop a comprehensive, group-wide supervisory and   regulatory framework for internationally active insurance groups (IAIGs)	October 2013
Finalisation   of IAIG framework	End 2013
Systemic   Risk Management Plan (SRMP) to be completed	July 2014
Crisis   management groups (CMGs) to be established for initial set of G-SIIs	July 2014
G-SII   designation of major reinsurers	July 2014
IAIS   to develop straightforward, backstop capital requirements to apply to all   group activities, including non-insurance subsidiaries	September 2014
CMGs to develop and agree RRPs,   including liquidity risk management plans for initial set of G-SIIs	End 2014
IAIS to develop implementation   details for HLA that will apply to designated G-SIIs starting from 2019	End 2015
Implementation   of SRMPs to be assessed	July 2016
FSB to designate the set of   G-SIIs, based on the IAIS methodology and 2016 data, for which the HLA policy   measure will apply, with implementation beginning in 2019	November 2017
HLA   requirements to apply to those G-SIIs identified in November 2017	January 2019

Insurance and the Question of “Too Big To Fail”

More from the FT, which provides an interesting update on the initiative to identify globally systemically important insurers.  Plans drawn up by the International Association of Insurance Supervisors are described as being “incoherent, impractical and simplistic” by the industry, which expresses particular concern about the intention to include variable annuities on the list of activities that are “non-insurance”, “non-traditional” or “semi-traditional” and hence subject to increased capital requirements.

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 22^nd 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.

EU Commission publishes consultation paper on RRP for non-banks

Introduction

On 5 October 2012, the European Commission published a consultation paper on a possible recovery and resolution framework for financial institutions other than banks.  The aim of the consultation is to ensure that all nonbank financial institutions the failure of which could threaten financial stability are capable of being resolved in an orderly manner and with minimal cost to taxpayers.  Responses are requested by 28 December 2012.  A more detailed summary of the consultation paper is provided below.

Defining ‘Systemic Risk’

The consultation paper concludes that, with the exception of central counterparties (CCPs) and central securities depositories (CSDs), it is difficult to establish in advance which nonbanks are likely to be sources of systemic risk.  As such, it is necessary to have a framework that applies to all firms, both those identified as systemic ex ante and after an event of failure.  As to the question of when a specific institution might be considered as being a source of systemic risk, the following are identified as key factors:

• size;
• inter-connectedness; and
• substitutability of services.

Financial Market Infrastructures (FMIs)

Central Counterparties

The Commission notes that there is a high risk of contagion associated with CCPs as:

• they are strongly inter-connected with other FMIs and other financial institutions;
• they often operate on an almost quasi-monopolistic basis; and
• clearing members of a CCP are often also clearing members of other CCPs, with the effect that losses suffered by a clearing member on the failure of a CCP could indirectly impact other CCPs (if these losses triggered a default vis-a-vis the other CCPs).

The consultation paper makes reference to measures employed by CCPs which act as safeguards with respect to the risks they face:

Risk	Safeguard
Credit risk and liquidity risk	Initial margin   Variation margin   Default fund contributions   Own capital
Operational risk	Contingency arrangements such as   those required by Article 34 of EMIR
Market risk	Investment restrictions such as   those required by Article 47 of EMIR Haircuts

 Central Securities Depositories

The principal risks to which CSDs are exposed are operational and legal in nature, with legal risks being particularly relevant given the cross-border nature of some CSD activities.  However, the services provided by CSDs are characterised by their high levels of interconnection and their low degree of substitutability.  Therefore, if managed in a disorderly fashion, the failure of a CSD could have considerable effects on the financial system.

Recovery and resolution of CCPs and CSDs

The most critical element of CCP/CSD resolution is to ensure the continuation of systemically important functions and services.  This is achieved through a combination of recovery and resolution plans.  Authorities should also be able to intervene in the business of a firm prior to the triggering of a resolution condition, if it is in breach of its regulatory requirements.  However, resolution of an FMI must be conducted in a manner which preserves the principle of ‘no creditor worse off than in insolvency’.  In addition, the normal hierarchy of claims in insolvency and pari passu treatment of creditors of the same class should be respected.

Resolution triggers for CCPs and CSDs are the same as for banks and should be set at the point when a firm is no longer viable or likely to be no longer viable, and has no reasonable prospect of becoming so.  A further condition for resolution is that its failure and the disruption of its services must have systemic implications.  The balance between the need for flexibility in triggering resolution on the one hand and the need for clarity as to the level of the trigger on the other hand are both recognised.

In the context of FMI resolution, authorities should have the power to:

• remove and replace a firm’s senior management;
• appoint an administrator;
• operate, restructure and/or wind-down a firm;
• transfer or sell specified assets or liabilities;
• establish a temporary bridge institution;
• separate non-performing assets into a distinct vehicle;
• recapitalise an entity by amending or converting specified parts of its balance sheet;
• override rights of shareholders;
• impose a temporary stay on the exercise of early termination rights;
• impose a moratorium on payment-flows; and
• effect an orderly closure/wind-down.

With respect to the resolution tools at the disposal of authorities, the difficulties of applying the Sale of Business tool is recognised, due to:

• the relative lack of firms in the industry;
• the different nature of an FMI’s assets and liabilities;
• operational constraints such as IT system incompatibility; and
• the competition issues which may flow from ownership structures.

In addition, as the core assets of an FMI (its technical facilities and processes, infrastructure and know-how) do not tend to cause losses in the way a bank’s assets might, they do not merit being transferred to a separate ‘bad’ asset management vehicle under the Asset Separation Tool.  In turn, these facts increase the importance of the Bridge Institution Tool as a method of resolving a failed FMI due to the fact that this will enable authorities to ensure the continuity of critical services whilst a private sector purchaser is identified.

Of most interest is the discussion of the use of the Bail-In Tool with respect to FMIs.  FMIs typically do not issue debt which can be made subject to a haircut or converted into equity for the purposes of loss allocation or recapitalisation.  It is noted that loss-allocation mechanisms, for example CCP default funds, already exist for some FMIs. However, these arrangements are primarily concerned with loss-allocation rather than recapitalisation.  With respect to the resolution of a CCP, the following options were identified:

Bail-In Option	Advantages	Disadvantages
Applying haircuts to initial margin	Funds are available for immediate use Initial margin levels may need   to increase across the board	Possibility that this departs from the principle of ‘no creditor worse off than in insolvency’
Applying   haircuts to payments of variation margin	Funds are available for immediate use Does not have pro-cyclical effects for out-of-the-money payors	Has pro-cyclical effects for in-the-money payees Possibility that this departs from the principle of ‘no creditor worse off than in insolvency’
Specific   liquidity calls on clearing members	Avoids random allocation of losses resulting from margin haircuts	Increased pro-cyclicality due to the fact that all clearing members are called for funds
Establishment   of ex-ante resolution funds	Avoids negative countercyclical   impact	Difficulty in calculating appropriate levels of contribution
Issuance of CoCo bonds by CCPs	Burden would not fall on clearing members	Uncertainty as to market for CoCo bonds

The Commission also noted that the industry has considered providing CCPs with a right to terminate contracts with non-defaulting clearing members for an amount equivalent to the contracts held on behalf of the defaulter so as to return the CCP to a balanced net position.

Insurance and Reinsurance Firms

Defining Systemic Importance

The consultation paper notes that most insurance business is unlikely to be systemically important due to its competitive nature and relatively low barriers to entry.  Traditional insurance is considered to be the least risky to the financial system.  In contrast, non-traditional insurance, such as bond insurance, implies a higher degree of risk as a result of its non-standard characteristics that makes it more interconnected with the rest of the financial system.  Non-insurance activities, such as entering into derivatives (particularly as sellers of credit protection) carry the greatest risk.  Although derivatives transactions are generally undertaken through different legal entities, they tend to be connected through a common parent, which sometimes acts as guarantor, meaning that an insurance entity in this position can be both a source or recipient of financial contagion for other entities in its group.

Applying these generalisation to specific areas of the insurance industry, the Commission concludes that short-term funded insurers (which issue commercial paper and reinvest the funds in assets offering a higher return or enter into repos in relation to securities comprised within their investment portfolios) could be systemically risky, but only if the practice is indulged in to an excessive extent and with inadequate liquidity and collateral management.  Similarly, any contagion from the failure of a reinsurer would be limited to its direct customers due to the “comparatively limited” nature of its connections.  However, other types of insurance are considered to have a greater potential to be systemically important due to their high inter-connection with the real economy and the fact that they do not constitute readily substitutable services.  Examples include:

• compulsory insurance such as motor insurance, employers’ liability insurance, professional indemnity insurance and warranty insurance; and
• trade credit insurance, by which a business receives protection against losses incurred by late payment or failure to pay by its buyers.

Recovery and resolution of insurance companies

In the case of systemic insurers, it is critical to ensure the continuity of policyholder protection, in relation to which recovery and resolution plans will play an important role.  Triggers to resolution and resolution powers also remain the same as for CCPs/CSDs.  However, with respect to resolution tools, the Commission notes that existing legislation is primarily designed to protect policyholders and is not designed to contain the wider effects associated with the failure of a systemic insurer.  Traditional resolution tools include:

• run-off;
• portfolio transfer;
• insurance guarantee scheme;
• bridge institution;
• restructuring of liabilities; and
• compulsory winding-up.

These tools are generally considered to be effective in conserving the value of an insurer’s assets and protecting policyholders from unnecessary losses.  However, in order to avoid the disruption to financial markets and the real economy associated with the failure of a systemically important insurer it is necessary to have a variety of alternative ways to carry out resolution, such as the ability to separate the systemically important non-traditional activities of the insurer from the traditional activities.

Again, “bail-in” in the context of insurance companies is of most interest.  This would entail the recapitalisation of an insurer by writing down debt and converting claims to equity, either in a bridge institution or in the original firm.  In doing so, it would be possible to ensure the continuation of critical services and provide sufficient time to facilitate the orderly reorganisation or wind-down of the failed insurer.  The consultation paper notes that bail-in could potentially apply to all liabilities of the institution with the exception of:

• secured liabilities;
• insurance policies;
• client assets; and
• other liabilities such as salaries, taxes or payments due to commercial partners.

Payment Systems And Other Nonbank Financial Institutions/Entities

Two types of entity are identified:

• Payment Systems (such as TARGET2 or CHAPS), and
• Payment Institutions (PIs) and Electronic Money Institutions (EMIs).

The Commission concludes that neither merits further consideration in the context of the consultation due to:

• the vital nature of payment systems, and their specific relationship with and oversight by central banks; and
• the fact the neither the failure of a PI nor an EMI is likely to represent a significant risk from a systemic point of view.

Other nonbank financial institutions

The consultation paper identifies other financial institutions, including investment funds and certain trading venues, which have not previously been discussed  and which could contribute to the build-up or transmission of systemic risk.  The Commission believes that the resolution of such entities is likely to be very similar to those for banks, investment firms, insurance companies and other entities captured by the consultation.

An RRP Timeline

Here is a link to an RRP Timeline.  I hope that you find it useful.

The yellow flags highlight some of the events which resulted in the initial RRP initiative.  The green flags represent the regulatory initiatives related to RRP, and the red flags show some of the deadlines that will apply to market participants affected by RRP legislation.

Apologies for the fact that it’s rather cluttered – there has been a lot happening with respect to RRP recently!  However, I wanted to set a bit of a benchmark with the first timeline.  Over time, I will update this, but focus more on future regulatory initiatives and deadlines and less on past events.

Ending “Too-Big-To-Fail”: FSB Progress Report to the G20

Last week, the leaders of the G20 met in Los Cabos, to discuss, among other things, the progress of financial regulatory reform, a key aim of which is to address the issue of financial institutions which are ‘too-big-to-fail.  The Financial Stability Board (“FSB”), tasked with overseeing this reform programme, published a report detailing progress in the implementation of the G20 recommendations.

The FSB report addressed three main areas:

• Improving the capacity to resolve firms in crisis;
• Improving the intensity and effectiveness of systemically important financial institution (“SIFI”) supervision; and
• Extending the SIFI framework.

Improving the capacity to resolve firms in crisis

General

The FSB Key Attributes of Effective Resolution Regimes for Financial Institutions outlines the essential elements of any resolution regime, highlighting the following requirements:

• the establishment of Crisis Management Groups (CMGs);
• the elaboration of recovery and resolution plans (RRPs);
• the conduct of resolvability assessments;
• the adoption of institution-specific cross-border cooperation agreements (COAGs); and
• the establishment of cooperation arrangements with jurisdictions that are hosts to systemic operations of a G-SIFI but are not represented on its CMG.

Crisis Management Groups and RRPs

The FSB reported that 24 out of 29 G-SIFIs have established CMGs, of which a few have discussed resolution strategies and ‘started to develop operational plans to implement them.’  However, the FSB concedes that, in many cases, the work of CMGs and the development of RRPs is restricted by the absence of ‘clearly articulated resolution strategies’, and has given priority to resolving this matter by the end of 2012.

Resolvability Assessments

The aim of a resolvability assessment is to highlight obstacles to resolution.  Again, there is an acknowledgement that the development of resolution strategies is a precondition of effective resolvability assessments.  The FSB concludes that such assessments should be conducted from Q1 2013, after the development of the necessary resolution strategies.

Institution-specific cooperation agreements

The FSB report states that no institution-specific cooperation agreements have been agreed to date.  This is due, in part, to the lack of developed resolution strategies and also due to the difficulties of sharing information across jurisdictions.  Therefore, the FSB will examine obstacles to the exchange of information with a view to developing minimum common terms and content for information sharing to be included within cooperation agreements by early 2013.

Cooperation with Non-CMG host jurisdictions

The FSB acknowledges that channels of communication need to exist between a CMG and host authorities that are not represented in the CMG, and proposes to develop further guidance on the matter.

Improving the intensity and effectiveness of SIFI supervision

More intense and effective supervision of SIFIs is posited as a key pillar of the FSB’s financial reform framework, and focuses on four key areas:

• Holding supervisors to higher standards;
• Improving supervisory tools and methods;
• Enhancing the effectiveness of supervisory colleges; and
• Improving firms’ risk data aggregation capabilities.

The consensus is that progress is being made in these areas, but that more work is needed. The development of uniform principles of banking supervision, (based on the BCBS’s Core Principles for Effective Banking Supervision) is underway, with a projected publication date of autumn 2012. Significantly, on the subject of improving supervisory tools and methods, the FSB concludes that ‘while resources at supervisory authorities have increased since the financial crisis, the pace of increase has not been commensurate with higher regulatory and supervisory demands.’ The report also highlights the relative lack of expertise across supervisory bodies, and the need to improve the risk measurement capabilities of supervisory colleges.  Finally, the FSB is compiling guidelines concerning firms’ risk aggregation capabilities, to be published by the end of the year, with firms being expected to begin implementation in 2016.

Extending the SIFI Framework

Domestic Systemically Important Banks (“D-SIBs”)

At the 2011 G20 summit, it was proposed that the G-SIFI framework, addressing the issue of ‘too-big-to-fail’, should be extended to cover D-SIBs. Whereas the G-SIB framework considers the global impact of banking failures, by realigning the framework, it is hoped that the externalities of bank failure at the local level can be identified and addressed. The Basel Committee on Banking Supervision (“BCBS”), in collaboration with the FSB, is in the process of developing a D-SIB framework which is compatible with that of the G-SIB, facilitates home-host coordination and improves D-SIB loss absorbency. The findings of the FSB and BCBS will be presented to the G20 Finance Ministers and Central Governors meeting in November 2012.

Global Systemically Important Insurers (“G-SIIs”)

The report further notes that the International Association of Insurance Supervisors (“IAIS”) was tasked with the ‘development of an assessment methodology for the identification of G-SIIs’ and has made significant progress to this end, publishing a paper on policy measures that should apply to G-SIIs.  A consolidated paper on the assessment methodology and the policy measures will be delivered to the G20 in April 2013, with an initial list of G-SIIs being produced soon thereafter. For more information on this aspect, please see the post on this blog entitled “Recovery and Resolution Plans for Globally Systemically Important Insurers by Mid-2014” dated 7 June 2012.

Non-bank G-SIFIs

In recognition of the fact that non-bank G-SIFIs can also cause widespread disruption to the global financial system, G20 leaders asked the FSB, with the International Organisation of Securities Commission (“IOSCO”) to design a methodology for identifying such institutions.  However, no date was given by which IOSCO is due to report.

G20 Leaders Declaration – Los Cabos 18-19 June 2012

On 20 June 2012, the G20 published its leaders’ declaration following the close of the Los Cabos summit.  The declaration was wide-ranging, but on the subject of economic stabilisation and the global recovery, the G20 affirmed its support for the ‘consideration of a more integrated financial architecture, encompassing banking supervision, resolution and recapitalization, and deposit insurance’ within the EU.

More specifically, the G20 also provided guidance on the future timetable for financial sector reform:

• reiterating its commitment to make national resolution regimes consistent with the FSB Key Attributes of Effective Resolution Regimes;
• supporting the ongoing development of recovery and resolution plans and institution-specific cross-border cooperation agreements for all G-SIFIs;
• reiterating its commitment to strengthen the intensity and effectiveness of the supervision of SIFIs and requesting the FSB to report on progress in this area in November 2012 at the G20 Finance Ministers and Central Bank Governors’ meeting;
• welcoming progress on the development of a common framework for the identification of, and policy measures relating to, domestic systemically important banks (D-SIBs);
• Requesting the FSB and the International Association of Insurance Supervisors (IAIS) to complete their work on identification and policy measures for global systemically important insurers by April 2013;
• looking forward to the preparation by the FSB and the International Organization of Securities Commissions (IOSCO) of methodologies to identify other systemically important non-bank financial entities by end-2012;
• calling on the Committee on Payment and Settlement Systems (CPSS) and IOSCO to continue their work on systemically important market infrastructures; and
• requesting the IAIS to continue its work to develop a common framework for the supervision of internationally active insurance groups by end-2013.

The full declaration can be found here.

 

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