Insurance Companies and Systemic Risk

By James Kwak

The systemic risk posed by insurance companies is something that I’ve never been entirely clear about. I know it’s an enormous issue for large insurers who want to avoid additional oversight by the Federal Reserve. I’m well aware of the usual defense, which is that insurers are not subject to bank runs because their obligations are, in large measure, pre-funded by policyholder premiums, and policyholders must pay a price in order to stop paying premiums. But this has never seemed entirely convincing to me, because some insurers are enormous players in the financial markets, and the nature of systemic risk seems to be that it can arise in unusual places.

So I find very helpful Dan and Steven Schwarcz’s new paper discussing the ins and outs of systemic risk and insurance. Because it’s written for a law review audience, it covers all the basics, so you can follow it even if you know little about insurance. They cover the usual arguments for why insurers do not pose a threat to the financial system, but then posit a number of reasons for why they could pose such a threat.

A big reason is that insurers make up a large proportion of the buy side, especially for particular markets—owning, for example, one-third of all investment-grade bonds. Furthermore, insurers tend to concentrate their purchases within certain types of securities that provide them with regulatory benefits (sound familiar?)—such as the structured products that promised higher yield while providing the investment-grade ratings that insurers needed. The big fear is that large numbers of insurers could be forced to dump similar securities at the same time, causing prices to fall and harming other types of financial institutions. This may seem unlikely, since insurers only have to make cash payouts when insurable events occur (houses burn down, people die). But insurers have to meet capital requirements just like banks, so falling asset values will require them to adjust their balance sheets.

Another major problem is that it’s not clear that insurers are prepared for those insurable events. For example, insurers are not prepared for a global pandemic, just like they weren’t prepared for large-scale terrorist attacks prior to September 11, 2001.

Finally (and I’m skipping several factors), it’s possible that entire segments of the insurance industry are under-reserving for certain types of risks. This stems from the usual cause: companies compete for market share, and the way to win share is to charge lower prices, and the way to charge lower prices is to underestimate risk. This is all good in the short term, resulting in larger bonuses, and bad in the long term, when the risk actually materializes. Yet it seems that insurance regulators are shifting to “a process of principles-based reserving (‘PBR’), which would grant insurers substantial discretion to set their own reserves based on internal models of their future exposures.” For even a casual observer of the last financial crisis, this sounds like the system is taking on a large amount of model risk and regulatory competency risk, and we know how that story ended last time.

Schwarcz and Schwarcz conclude that the federal government should play a larger role in monitoring systemic risk in the insurance industry, which will make them just about the least popular people in most insurance circles. Given the downside risks, though, it seems like pretending that there’s no reason to worry about insurers is not a good long-term strategy.


11 thoughts on “Insurance Companies and Systemic Risk

  1. The insurance industry is a farce, large amounts of time and money go into not paying claims they are legally committed to, instead they fleece the consumer and the gvt both at the same time. That’s how good they feel they are, but in the end, they dead wrong.

  2. Given the power of modern computers, and the deregulation of the FIRE sector, it’s almost inevitable that our society would shift as much as possible into FIRE. After all, it’s basically an industry based on promises and if no one is checking those promises and computers can allow those promises to be ever more complex (and therefore hard to bring to account), promises will quickly become lies. And in FIRE, if your lies are ever brought out into the open, it’s because of a massive economic shock, which is your ultimate “no one’s fault” asterisk. If you manufactured widgets and lied about the cost to get the price down and later couldn’t deliver the widgets as a result, you would not be forgiven. Therefore the ephemeral world of FIRE is much more attractive.

    Part of me secretly hopes that the financialization of the West will cause the current economic system to collapse before the current economic system causes irreversible environmental collapse. If humanity is a virus to the Earth, it may be creating its own self-limiting toxin that will limit itself prior to killing the host.

  3. This Wednesday, my partners, our attorney, and our Milliman actuary are meeting the Texas Department of Insurance people who will be analyzing our application to be a health insurer in Texas. It has been made clear to me that Texas requires $2.40 of reserves for every dollar of premium for health insurance reserves.
    My understanding of how an insurer can invest its reserves is that it is limited to no more than 10% invested in stocks.
    Apparently, most of a health insurer’s investments are in bonds and real estate.
    In regards to bonds, how can insurers make much money in such a low interest rate environment?
    The only sector that seems to have appreciated is the stock market, yet, due to its excessive risk, investments are highly limited.
    I will, of course. learn more, over the next 4-8 weeks.
    Don Levit

  4. There needs to be a formal and predictable way to properly measure systemic risk. However, I’m still fuzzy about how an insurer can invest its reserves.

  5. Banks and politicians have a bargain. Banks finance politicians, and politicians provide banks with subsidies in the form of deposit insurance and low interest loans. As part of the deal, politicans ensure banks that regulators will be useless. This relationship – seen across the globe and over time – ultimately leads to financial crisis and taxpayer bailouts.

    The marriage between insurance companies and politicians is not as strong or clear cut. Regulators do a better job because insurance companies don’t have as much to offer politicians.

  6. “For profit” health insurance, unless it re-invests in manufacturing health care products (surgical, cotton balls, drugs, etc etc etc) serves as yet another cynical extraction scheme.

    CNBC casually noted today in conversation that 91 million USA adults are NOT on the receiving end of any flow of $$$$ TO them (AKA “jobs”), they participate in the economy only in the extraction algorithm. Why is Yellin’s hair not on fire?

    More misery for others = More $$$$ for ME ME ME

  7. “Schwarcz and Schwarcz conclude that the federal government should play a larger role in monitoring systemic risk in the insurance industry” (snip)

    Like how the banking sector has turned out? Then move to one national regulator that can be gamed liked the OCC, etc.

    The BEST thing about insurance regulation in the USA is that remains at the state level, where fifty separate offices have prevented this sort of foul play.

  8. “But insurers have to meet capital requirements just like banks, so falling asset values will require them to adjust their balance sheets”

    – For one thing, insurance capital requirements are based on statutory capital not GAAP and for most purposes statutory capital doesn’t mark to market. If a debt security has taken a real impairment it must be written down but a market liquidity run which just affects trading price – not anticipated recovery – won’t really flow into statutory capital and thus won’t trigger a run.

    As for a big insurable event, if an insurer does go belly up then it goes into the land of insurance insolvency which is a long drawn out process designed to protect policyholders. No it can’t make money appear from thin air but it doesn’t lead to a quick panic firesale.

  9. For the first time in the history of this blog I haven’t been able to keep up with the posts. I will catch up though sometime before April 8. In the mean time, THANK YOU FOR THE AWESOME INSURANCE PAPER LINK. I LOVE THESE TYPE THINGS—–FREE. GOD BLESS.

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