Good regulation for the banking industry is good for insurance right?!
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1 Good regulation for the banking industry is good for insurance right?! The influence of evolving banking and insurance regulatory frameworks on financial stability Jérôme Berset Head of Risk Governance and Reporting Helsinki, Finland 29 November 2011
2 Agenda 1. Setting the scene: evolving regulatory frameworks 2. Interactions between Solvency II and Basel III 3. Implications of Solvency II and Basel III on financial stability 4. Concluding remarks 2
3 Canadian RBC System Finalnd RBC US Life RBC Canada Life DST Canada P&C DST Australia RBC Singapore RBC FSA Realistic Balance Sheet UK ICA, NL DST Swiss SST NAIC: Solvency Modernization initiative launched Group/ Dynamic model Swiss SST IAIS: ComFrame initiative Systemic risk challenge Campagne publishes reports on life and nonlife solvency assessment 1. EU Life Directive 1. EU Nonlife Directive Muller report Start of Solvency 2 KPMG Report Sharma Report CEIOPS Established CEIOPS QIS1 CEIOPS QIS2 CEIOPS QIS3 CEIOPS QIS4 Solvency II Directive EIOPA established (with EBA and ESMA) QIS5 Solvency ii: soft l launch and implemention SEC VaR Measure Basel Accord CBOT SPAN Amendment Start of Basel II Implementation Of BaselII Financial Crisis Publication of Basel III rules text Banking recapitlization What are the main elements of the regulatory reforms? Banking Market Risk European International Source: amended from FINMA 3
4 The challenge of evolving regulatory reforms Walter Kielholz (Chairman of the IIF Insurance Working Group) on the Implications of Financial Regulatory Reform for the Insurance Industry 1 It is essential that regulators, when formulating regulations for one sector, take fully into account the potential spill over effects of their actions on other sectors. The objective is not to strive for harmonized regulation in banking and insurance as the two sectors have important differences in terms of business models and the roles they play in the economy and society at large. Rather, it should be to achieve regulation that is aligned with similar risks run by firms in the respective sectors but whose design is informed by these cross-sectoral effects. Banking regulation affects insurers and vice versa and both sets of regulation will be less effective if these spill-over effects are insufficiently recognized. (Opening Press Conference Statement; London, August 17, 2011) 1 The Institute of International Finance (IIF) Insurance Working Group, in collaboration with Oliver Wyman, released a report in August 2011, highlighting the potential impact on the insurance industry of regulatory reforms in both banking and insurance. The report calls for greater cross-sectoral coordination in developing regulatory reforms. 4
5 Agenda 1. Setting the scene: evolving regulatory frameworks 2. Interactions between Solvency II and Basel III 3. Implications of Solvency II and Basel III on financial stability 4. Concluding remarks 5
6 Insurers and banks are different in many important ways Key differences between the banking and insurance industries necessitate different approaches to regulation Fundamental differences Purpose Insurers most fundamental purpose is to pool policyholders risk of adverse events, thereby providing protection against future uncertainty Banks, however, while pooling credit risk, also perform maturity transformation by using shortterm funding to finance long-term lending Nature of liabilities Insurance liabilities, particularly those in the life sector, tend to be long-dated and can be subject to penalties upon early forfeiture: P&C liabilities, although often short-term, are largely uncorrelated with economic and financial cycles Liabilities for primary insurers tend to be to policyholders, not other financial institutions Bank liabilities are generally short-term and most are immediately redeemable upon request Nature of assets Insurers tend to invest in long-term assets and are less affected by short-term volatility in market prices Implications Asset-liability management (ALM) The ability to match the maturities of assets and liabilities is key to effective management of an insurer Difficulty buying instruments of certain durations may materially affect ALM programs Liquidity concerns Due to the long-term nature of liabilities, insurers rarely experience the kind of liquidity crises faced by banks Insurance policies are often difficult to redeem early or without notice Resolution Closures in the insurance industry tend to be orderly, as policies are long-dated, policyholders do not need to be repaid immediately The need for living wills is less for insurers, particularly as many regulators have in place policies for winding up Systemic importance Insurers core businesses do not pose systemic risk (including the FSB/IAIS criteria of size, interconnectedness, substitutability, timing of payout) 6
7 Comparing Solvency II and Basel III Solvency II Lead European Commission (EC) European Insurance and Occupational Pensions Authority (EIOPA) Basel III Basel Committee on Banking Supervision (BCBS) Approach Primarily principle based Rules based Regional scope A directive that will be binding in 30 European Economic Area (EEA) countries An accord /agreement with no legal force but potentially global applicability Balance sheet Total balance sheet view Credit and operational risk Liquidity and ALM risk (Basel III) Valuation Fair value Trading book: fair value Banking book: amortized cost Models Full and partial internal models or standard model Time horizon Models are calibrated to long-term observations of historical events Formulaic approach Only short-term series of historical data necessary Definition of time series lies with the company and relies on its data 7
8 Solvency II and Basel III Potential unintended consequences Bottom line Both frameworks take a risk-based approach to minimum capital requirements and supervision and promote the integrated use of models by institutions in managing risks and assessing solvency It is very difficult however to compare capital requirements under the two frameworks: - Basel III attempts to increase the overall quantum of capital and its quality as a mean of protecting against bank failures - Solvency II attempts to enhance the quality of capital and tailor the quantity of capital required more closely to the risks of each insurer (without necessarily increasing the quantity within the sector as a whole. It also has a strong focus on risk management. - It is very likely that some similar risks have different capital charges under the two accords These differences can lead to unintended consequences 8
9 Agenda 1. Setting the scene: evolving regulatory frameworks 2. Interactions between Solvency II and Basel III 3. Implications of Solvency II and Basel III on financial stability 4. Concluding remarks 9
10 Varying treatment of assets across regimes (1/4) Corporate and Sovereign bonds Criteria Differences Consequences Corporate bonds Duration, credit rating As the duration of bonds increases, so does the capital charge under both Solvency II and Basel III. Solvency II s capital charge increases much faster than Basel III s. The maximum is also substantially higher. The NAIC makes no distinction based on duration, and instead chooses to apply a flat rate to all bonds by rating. European insurers are incentivized to hold short-dated, lower-quality bonds than banks and American insurers. Insurers, which hold long duration assets to match the duration of their liabilities, should not be dis-incentivized from buying longer term bonds. Conversely banks, which are characterized by much shorter term liabilities have a relative incentive to take more long-term risk. Sovereign bonds Duration, credit rating Under Solvency II, zero capital is assigned to European Economic Area sovereign debt For Basel III, zero capital is assigned to sovereign debt of the EEA or US The NAIC uses the same scales as for corporate bonds for non-us sovereigns. Solvency II institutions and European banks are strongly incentivized to hold EEA debt even if it is poorly rated. The bias towards sovereign debt is reinforced by the fact that the capital charges even for non-eea debt are substantially lower than similarly rated corporate debt. This distortion may lead to over-weighting of sovereign bonds, particularly of EEA nations, in the portfolios of European banks and insurers. Source: IIF/Oliver Wyman The Implications of Financial Regulatory Reform for the Insurance Industry, 8/
11 Credit quality Varying treatment of assets across regimes (2/4) Residential mortgages Basel institutions have a relative incentive for loans with relatively higher LTV and of high credit quality Higher Lower LTV Solvency II institutions have a relative incentive for loans with relatively low LTV, regardless of credit rating NAIC Life institutions have a relative incentive for loans with higher LTV and lower credit quality Source: IIF/Oliver Wyman The Implications of Financial Regulatory Reform for the Insurance Industry, 8/
12 Required capital Varying treatment of assets across regimes (3/4) Picturing the differences in capital requirements for residential mortgages 6.0% 5.0% Basel B 4.0% 3.0% Basel BB Solvency II 2.0% NAIC Life Basel BBB 1.0% 0.0% 65% 70% 75% 80% 85% 90% 95% 100% Basel A Basel AA Basel AAA Higher security LTV Lower security Source: IIF/Oliver Wyman The Implications of Financial Regulatory Reform for the Insurance Industry, 8/
13 Varying treatment of assets across regimes (4/4) Unintended consequences Regulatory observation Regulatory outcome Incentive created by regulation Potential impact Longer-dated corporate debt has a higher probability of default at equal ratings quality Higher capital requirements for longerdated corporate debt Shorten duration of investment portfolio Increase reliance on derivatives to ensure proper ALM Less market-wide demand for long-dated assets Insurers at risk to lower rates or must seek maturity transformation in the capital markets Credit risk of domestic governments in local jurisdictions is assumed low Zero capital requirements for sovereign debt; liquidity regulations mandate holding sovereign debt. Overweight highyielding sovereign debt in portfolio High exposure to sovereign default risk across industry Inherent value of residential mortgages depends on the value of the underlying collateral Solvency II capital requirements for mortgages depends on Loan-to-Value (LTV), without regard to credit quality Insurers overweight lower LTV mortgages to lower quality borrowers in portfolio Impacts mortgage economics of banks Possible relative overextension of credit for these borrowers Source: IIF/Oliver Wyman The Implications of Financial Regulatory Reform for the Insurance Industry, 8/
14 A further challenge to financial stability How to finance bank capital requirements under Basel III? Banks need significantly more capital under Basel III - The implementation of Basel III will require banks to raise possibly as much as $750 billion (current estimates, including those of the BCBS) - The new liquidity ratio requirements under the net stable funding ratio will require banks to issue very large volumes of medium to long term debt, which could represent an increase of approximately 18% in total bank securities outstanding Importance of insurers as providers of bank funding - The expectation of banking regulators, for example, may be that insurers will play a major role in any major bank equity debt issuance, however the willingness and ability of the insurance sector to provide a ready market for new capital and funding may be quite limited. - Even if insurers were willing to increase their exposure to bank assets in the form of debt, new insurance regulation and sound risk management will tend to militate against any further increase, particularly of long term funding - bank debt already makes up a significant portion of insurers portfolios. Source: IIF/Oliver Wyman The Implications of Financial Regulatory Reform for the Insurance Industry, 8/
15 The systemic risk challenge The same battle for banks and insurers? Rationale for capital surcharges on banks* Banks Insurers Large/complex banks have intrinsically systemic characteristics Extremely difficult to resolve large/complex banks subject to precipitate collapse and rapid loss of value Higher capital reduces likelihood of default and offsets difficulty in resolving Core insurance is not intrinsically systemic Long term liabilities Not leveraged No significant maturity transformation Not central to payments system No comparable resolution issues Long term liabilities Resolution/failure over long time periods No precipitate loss of creditor value Higher capital may reduce Pd But no comparable resolution issues Capital should be applied at the instrument/transaction level *NB IIF doesn t accept the rationale for banks either! Source: IIF/Oliver Wyman The Implications of Financial Regulatory Reform for the Insurance Industry, 8/
16 Agenda 1. Setting the scene: evolving regulatory frameworks 2. Interactions between Solvency II and Basel III 3. Implications of Solvency II and Basel III on financial stability 4. Concluding remarks 16
17 Solvency II as cornerstone to financial stability A consistent and comprehensive framework for the insurance industry Solvency II... will fundamentally transform the capital requirements and risk management practices of the European insurance industry players will take a total balance sheet view and introduce risk-based capital requirements will strengthen group supervision and create an environment in which the insurance industry can operate efficiently and promote financial stability and economic growth will introduce a ladder of intervention with minimum capital requirements and target solvency capital requirements that act as early warning indicator will require the European industry to enhance their risk management practices 17
18 A good regulation for insurers has common features with the banking regulation Enhanced supervision is critical for both sectors No case for separate systemic supervision model - it should become increasingly intensive as risk increases Regulation should leverage industry sound practice Insurance may lead the way in much industry sound practice more to do in comparative risk governance Need for heightened focus on comprehensive, group-wide supervision to identify and address material non-traditional and non-insurance activities 18
19 under the condition that the focus of evolving reforms remains on coordination, not harmonization Capital requirements can have unintended consequences by affecting firms asset allocation decisions: Corporate and Sovereign debts Role as long-term investors Funding of banks Differentiated answers to the systemic risk challenge 19
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