1. Do Insurance Companies Pose Systemic Risk?
J. David Cummins
2013 China International Conference
on Insurance and Risk Management
Kunming, China
July 18, 2013
Copyright J. David Cummins, 2013, all rights reserved. Not to be reproduced without author’s permission. 1 1 1 1 1

2. Outline of Presentation
What is Systemic Risk?
Systemic Risk: Primary Indicators – Factors Used to Identify Systemically Important Financial Institutions
Systemic Risk: Contributing Factors – Factors Exacerbating Vulnerability to Crises
Conclusions: Does Insurance Pose Systemic Risk?
Based on primary indicators and contributing factors
Are Insurers Instigators and/or Victims of Systemic Risk?
An econometric analysis using Granger causality

3. This Presentation Based on Two Papers
Cummins, J. David and Mary A. Weiss, 2013, “Systemic Risk and the Insurance Industry,” forthcoming in Georges Dionne, ed., Handbook of Insurance, 2d ed. (Springer).
Chen, Hua, J. David Cummins, Krupa Viswanathan, and Mary A. Weiss, 2013, “Systemic Risk and the Inter-Connectedness between Banks and Insurers: An Econometric Analysis,” forthcoming, Journal of Risk and Insurance.
Other relevant papers
Chen, Hua, J. David Cummins, Krupa Viswanathan, and Mary A. Weiss, 2013, “Systemic Risk Measures in the Insurance Industry: A Copula Approach,” working paper, Temple University, Philadelphia
Cummins, J. David and Mary A. Weiss, 2013, “Systemic Risk and the Regulation of the U.S. Insurance Industry,” working paper, Temple University, Philadelphia.
Cummins, J. David and Mary A. Weiss, 2012, “Systemic Risk and the U.S. Insurance Sector,” forthcoming, Journal of Risk and Insurance.
To obtain the papers, please

4. What is Systemic Risk? 4

5. What Is Systemic Risk?
The risk that an event will trigger a loss of economic value or confidence in a substantial segment of the financial system serious enough to have significant adverse effects on the real economy. Group of 10 (2001).
Systemic financial risk involves
A system-wide financial crisis accompanied by a sharp decline in asset values and economic activity
The spread of instability throughout the financial system (contagion)
Sufficient to affect the real economy World Economic Forum (2008).
Systemic risk is exposure to extreme correlations

6. Financial Crises and Systemic Risk
Prices of risky assets drop sharply
Prices of safe assets increase (flight to quality)
Asset price volatility increases
Liquidity dries up (rising bid-ask spread & price impact)
Financial institutions become financially distressed
Credit markets dry up, economic activity depressed
Financial systemic risk: Financial crisis in which many institutions become financially distressed, with a potential impact on real economic activity
Financial distress of one or a few institutions does not necessarily equal systemic risk!

7. Too-Big-To-Fail Has Been With Us For a Long Time and Isn’t Confined to Financial Institutions
Industry/Company
Year
Type of Assistance
Penn Central Railroad
1970
$676.3 million in loan guarantees – Gov’t spent $19.7 billion and got back about $4 billion
Lockheed
1971
Government loan which was paid off
New York City
1975
Loans and loan guarantees
Chrysler
1980
Loan guarantees and warrants – Gov’t earned a profit of about $660 million
Continental Illinois
1984
Government took 80% ownership and phrase TBTF was coined
Airline Industry
2001
Government bought stock below market and provided loan guarantees
Automobile industry
Government takes equity stake in GM & Chrysler = $80 billion
US Government bailouts of industries in the US isn’t new.
In 1970, the government took over Penn Central, injected some 19.7 billion in funds and provided $676 billion in government guarantees,
In 1971 we provided a loan to Lockeed
And in 1975, NYC, who had engaged in profligate spending was provided loans and Loan guarantees.
Our recent investments in Chrysler and GM aren’t new either. In 1980 we provided loan guarantees and obtained warrants for the support provided to Chrysler.
In 2001 we bailed out several of the airlines, buying stock and providing loan guarantees.
In terms of Banks, the first real significant venture, aside from the forbearance provided to Citicorp was when Continental Illinois bank went under
Where did it came from for banks?

8. Systemic Risk: Primary Indicators & Contributing Factors8

9. Primary Indicators and Contributing Factors
The Question: How to identify systemically risky markets and institutions?
Primary indicators: Factors used to identify systemic markets and institutions
Contributing factors: Determine the vulnerability of an institution or market to systemic events
An institution may be systemic in terms of primary indicators but not vulnerable in terms of contributing factors

10. Primary Indicators of Systemic Risk
Size – Macroeconomic Importance of Insurers
Size not limited to conventional measures such as assets
Volume of transactions, exposure to off-balance sheet positions, and derivatives also play a role
Interconnectedness – degree of correlation and potential for contagion among institutions
Lack of substitutability –
Are there effective substitutes for an institution’s products?
Are the products critical to the functioning of the financial system

11. Primary Indicators: Size
Conventional measures – assets or equity, absolutely or relative to GDP
Off-balance sheet exposures and volume of transactions processed
“Callability” of positions taken – marginability, etc.
Notional value of derivatives exposure (e.g., AIG’s credit default swaps positions)
“Too Big to Fail” being replaced by “Systemically Important Financial Institution (SIFI)”
Reflects inadequacy of conventional size measures

12. Designating SIFIs Financial Stability Oversight Commission (FSOC)
Established as part of U.S. Treasury in 2010
Can designate banks and non-banks as SIFIs
Thresholds for SIFIs
≥ $50 billion of assets, and
Meets or exceeds any one of several thresholds
$30 billion notional CDS for which firm is reference credit
$3.5 billion of derivative liabilities
$20 billion of total outstanding debt (bonds, etc.)
15-to-1 leverage ratio (assets/equity)
10% ratio of short-term debt to assets

13. Primary Indicators: Interconnectedness
Could Insurers Cause a “Run on the Bank”?
Interconnectedness – extent to which financial distress at one or a few institutions increases probability of distress at other institutions
Network or “chain” effects on both sides of balance sheet or through derivatives exposures, off-balance sheet commitments, etc.
Existence of “contagion” in the economy
Interconnectedness creates conditions that trigger “runs on the bank”

14. All Systemic Financial Crises Involve “Runs”
In crises, investors seek cash at all costs
As prices no longer adjust supply, access to credit becomes central
Maturity mismatch compounds shock and spreads runs
Rapid withdrawals lead to “fire sales,” prices crash
Losses induce margin calls, more fire sales
Runs are both cause and consequence of extreme correlation
Crises that do not spread to general credit market do not qualify (e.g., “dot-com” bubble collapse in )

15. Types of “Runs”
In the past (e.g., 1930s), financial crises often involved “retail runs”
Many depositors try to withdraw money from banks simultaneously
Deposit insurance has virtually eliminated retail bank runs
Recent financial crisis involved “wholesale runs”
Banks refused to provide liquidity to troubled institutions such as Lehman Brothers
AIG counterparties demanded higher margin deposits and the unwinding of asset lending relationships
Essentially, a “run” on the shadow banking system

16. “Runs” Triggered by Exposure to Common Shocks
Common shock may be exposure to agricultural depression, real estate, or oil prices
In the Crisis of , common shock was the bursting of the housing price bubble
Bursting of bubble triggered crises in
Inter-bank lending
Commercial paper
Market for short-term repurchase agreements (“repos”)
Essentially a run on the shadow banking system

17. “Too Big to Fail” & “Too Interconnected to Fail”
Institutions that pose significant systemic risk are viewed as “Too Big to Fail” -- e.g., failure would cause ripple effects throughout the economy due to the sheer size of the enterprises
“Too Interconnected to Fail” -- Firms with multiple counterparty relationships could trigger a cascading chain of failures – “domino effect”

18. Primary Indicators: Lack of Substitutability
Could Unavailability of Insurance Cause a Financial Crisis?
Substitutability – extent to which other firms or segments of the financial system can provide the same services provided by the failed institutions
For substitutability to be a problem, the services must be critical to the functioning of other institutions or the financial system
Payment system – operational arrangement that enables individuals and institutions to transfer funds
Settlement system – enables transfer of securities and cash to settle trades
Liquidity system – inter-bank lending, repos, etc.

19. Contributing Factors: Enhance Vulnerability to Systemic Events
Leverage
Measured conventionally as debt to equity
Off-balance sheet positions, options exposure, and “marginability” of positions also creates leverage
Leverage and “loss spirals”
Declines in asset values erode net worth much faster than the asset declines themselves (“leverage”)
E.g., at 10-to-1 assets/equity ratio, 5% decline in assets means 50% decline in equity
If many institutions are affected at same time, selling assets puts additional pressure on prices generating a loss spiral

20. Contributing Factors: Liquidity Risk and Maturity Mismatches
Liquidity risk – vulnerability to shocks is increased to the extent the institution holds illiquid assets
Difficulties in obtaining financing may trigger need to sell assets – problematic for illiquid assets
Especially serious if other institutions also illiquid
Asset-liability maturity mismatch raises liquidity risk
In Financial Crisis, Shadow banks used short-term commercial paper, overnight lending, and repos to finance longer-term assets
Disappearance of short-term financing triggered need to sell illiquid longer-term assets

21. What Are Repos?
Repos – abbreviation for “sale and repurchase agreement”
Defined: Sale of securities together with an agreement for the seller to buy back the securities at a later date
Repurchase price > original sale price, the difference representing interest, the “repo rate”
Seller is a borrower, using securities as collateral for a cash loan at specified interest rate
The buyer acts as a lender
During financial crisis, repo buyers refused to extend credit to firms such as Lehman

22. Contributing Factors: Complexity Enhances Vulnerability to Shocks
Dimensions of complexity
Complexity of organization or group structure – firms offering banking, insurance, and investment products more complex than single industry firms
Geographical complexity – multi-national firms face variety of local and regional risk factors
Product complexity exposes firms to risks that may not be fully understood
E.g., AIG Financial Products CDS transactions
Complexity aggravated by opacity
AIG’s positions were opaque, preventing market adjustment for over-exposure

23. Contributing Factors: Government Policy and Regulation
Government policy and regulation can contribute to financial system fragility
Deposit insurance and guaranty funds create moral hazard that may lead to crises – buyers with government guarantees have no incentive to monitor
“Too Big To Fail” policies also create moral hazard
Complexity of AIG created regulatory blind spot that led to AIG’s near collapse (nominally regulated by Office of Thrift Supervision)
US government policy permitted investment banks to become over-leveraged, helping to precipitate crisis
Lack of regulatory oversight contributed to the housing bubble and mortgage backed securities crisis

24. Size Risk: The Macro-Economic Importance of Insurers24

25. Total Assets: US Banks and Insurers
Assets: Banks $14.6 trillion, insurers $6.8 trillion.
Source: Federal Reserve Flow of Funds accounts.

26. Total US Life and P-C Premiums: % of GDP
Source: A.M. Best Company, American Council of Life Insurance, St. Louis Federal Reserve Bank.

27. US GDP From Financial Services (Value Added)
Source: US Department of Commerce, Bureau of Economic Analysis.

28. Insurance Companies: Share of Total Assets
Source: Federal Reserve Flow of Funds Accounts.

29. Conclusions: How Big Are Insurers?
Insurers have $6.8 trillion in assets
About 50% as large as commercial banks
Only about 8% of total US financial assets
Insurers do not have large share of any asset market
Insurer insolvencies resolved gradually so even large insolvency would not lead to liquidity problems
Insurers not very important source of GDP (< 3%)
Therefore, as a sector insurers do not pose systemic risk due to their size alone

30. Interconnectedness Risk: Could Insurers Cause A “Run on the Bank”?30

31. Interconnectedness: Insurers and Other Financial Firms I
Do US insurers invest heavily in other financial institutions?
Investment in Banks:
5.6% of insurer assets are in bank bonds
1% of insurer assets and in bank equities
Investment in Securities firms:
1.6% of insurer assets in securities firm bonds
1% of insurers assets in securities firm equities
Conclusion: Insurers are not vulnerable to stock and bond declines from financial firms

32. Interconnectedness: Insurers and Other Financial Firms II
Are insurers a significant source of funds for other financial institutions?
Life insurers supply:
9.4% of outstanding bonds for banks
14.1% of outstanding bonds for securities firms
However, bonds account for only 10% of financing for banks and securities firms
Conclusion: Banks and securities firms are not dependent on insurers to finance their activities

33. Interconnectedness Within Insurance Industry
Reinsurance is the primary source of intra-industry interconnectedness
Reinsurance creates risk of counterparty default
Reinsurer failure to pay claims can trigger insurer insolvencies
Insolvent insurers then default on their reinsurance counterparties
Result: A Reinsurance spiral
Reinsurance counterparty risk present for both
Reinsurance transactions with affiliates
Non-affiliated reinsurance transactions

34. Measures of Reinsurance Interconnectedness
Reinsurance premiums ceded
Insurance in force ceded (life)
Reinsurance receivables – funds owed by reinsurers to ceding company
Write-down of liabilities due to reinsurance:
Reserve credit taken (life)
Net amount recoverable from reinsurance (P-C)
If reinsurers fail:
Default on receivables and ceded premiums
Liability write-downs canceled, increasing leverage

35. Extent of Reinsurance Interconnectedness
Reinsurance premiums ceded to affiliates & non-affiliates
P-C premiums ceded = 17.2% of surplus
Life premiums ceded = 38.0% of surplus
Insurance in force ceded (life) = 55.3% of surplus
Reinsurance recoverables –
For 25% of P-C insurers, recoverables > 40% of surplus
For 25% of life insurers, recoverables > 100% of surplus
Write-down of liabilities due to reinsurance:
Reserve credit taken (life) averages 149% of surplus
Recoverables (P-C) average 39% of surplus

36. Have Reinsurance Failures Been a Significant Source of Insurer Insolvency?36

37. P/C Impairments: Triggering Events
Deficient loss reserves, inadequate pricing, and rapid growth are the leading triggers. Investment, catastrophe, and reinsurance losses play a much smaller role.
Source: A.M. Best: Impairment Review, Special Report, May 2, 2011.

38. L-H Impairments: Triggering Events
Life insurers more susceptible to affiliate problems.
Inadequate pricing, affiliate problems, rapid growth, and investments are primary causes of L/H insolvencies.
Source: A.M. Best: U.S. Life/Health – Impairment Review, Special Report, May 23, 2011.

39. Reinsurance Interconnectedness: Conclusions
Reinsurer failure traditionally not a major source of insurer insolvency
Many insurers do have large reinsurance counterparty exposure relative to surplus
Therefore, reinsurance failure could threaten solvency of individual insurers and create industry-wide crisis
However, it is unlikely that even a major intra-industry crisis would spill over into broader financial markets
Therefore, reinsurance causes intra-industry vulnerability but not systemic risk

40. Interconnectedness and Non-Core Activities
Insurer non-core (“banking”) activities can create interconnectedness and systemic risk
Example: AIG Financial Products
Non-core activities that may be systemic
Credit derivatives transactions
Asset lending programs
Financial guarantees and other off-balance sheet commitments
Reliance by insurers on short-term financing
Subsidiaries with high exposures relative to capital
Improved regulation needed to prevent crises

41. Substitutability Risk: Could Unavailability of Insurance Cause a Financial Crisis?41

42. Lack of Substitutes and Crises
For lack of substitutability to cause a crisis both of the following must be true:
The product must be unavailable and have no substitutes or alternative suppliers
The product must be essential for the functioning of other institutions or the financial system

43. Quantitative Measures of Substitutability
For lack of substitutability to cause a crisis:
Concentration (market share of top firms) – highly concentrated markets more likely to trigger crisis due to lack of substitutes
Ease of entry into the market
If entry barriers exist, new entrants prevented form providing vital products or financial services
Ease of entry can mitigate concerns about lack substitutability

44. Concentration and Regulation in Insurance
Concentration in insurance: US
Top 4 (10) non-life groups have 29% (50%) of market
Top 4 (10) life groups have 24% (45%) of market
Entry of new insurers relatively easy (both on shore and off-shore, e.g., Bermuda)
Nationally significant insurers reviewed quarterly by the NAIC – Financial Analysis Working Group
Therefore, widespread insolvencies causing insurance unavailability are extremely unlikely
Survivors or new entrants would provide coverage

45. Do Insurance Products Have Substitutes?
Life Insurance
Mostly asset accumulation products rather than mortality/longevity risk bearing
Many non-insurance substitutes for asset accumulation and investment products
Banks, mutual funds, securities firms, etc.
Many insurers available to fill coverage gaps resulting from insolvency of one or a few firms
Therefore, lack of substitutes not a problem for life insurance

46. Do Insurance Products Have Substitutes?
Property-Casualty (PC) Insurance
Mainly provide risk management and risk-bearing
No real substitutes for individual buyers (auto insurance) and small commercial customers
But many insurers are available to fill coverage gaps resulting from one or a few insolvencies
Large corporate buyers have substitutes – self insurance, captives, securitization
Therefore, lack of substitutes not a problem for P-C insurance

47. Is Insurance Critical to Functioning of Economy?
Insurance clearly enables the economy to function more smoothly by enabling individuals and businesses to take more risk
However, it is difficult to argue that insurance is as important as banking, the payments system, or the settlement system
Various insurance markets regularly experience availability crises without significantly affecting real economic activity
Therefore, unavailability of insurance unlikely to create a systemic crisis

48. Contributing Factors: How Risky Are Insurers?48

49. Contributing Factors: Leverage and Insolvency Rates49

50. Equity Capital-to-Assets Ratios
Source: Federal Reserve Flow of Funds accounts, American Council of Life Insurance, FDIC.

51. Premiums-to-Surplus Ratios: US Insurers
Insurance leverage ratios have been improving over time.

52. Failure Rates: US Banks & Insurers
Bank failure rate was more strongly affected by the crisis.

53. P/C Insurer Impairments: 1969-2011
Financial Crisis Did Not Trigger Many Impairments.
Source: A.M. Best; Insurance Information Institute

54. Why Did PC Impairments Increase in 2011?
Lingering effects of financial crisis
Crisis appears to have had delayed effect on P-C insurers
Near record catastrophe losses
Insured losses of $116 billion
2nd largest year for catastrophes in recorded history (largest was 2005 when Hurricanes Katrina, Rita, and Wilma and other events caused losses of $123 billion)
“Soft market” phase of underwriting cycle
PC insurance supply increases and prices decrease

55. PC Insurer Impairments & Combined Ratio
Impairment rates highly correlated with underwriting performance.
Correlation with combined ratio = 64%
Source: A.M. Best; Insurance Information Institute

56. Life/Health Insurer Impairments:1976-2011
Life/health impairments less cyclical than P/C
Source: A.M. Best.

57. LH Impairment Frequency & Profits
LH less correlated with profits than PC, Corr = -20%
Source: A.M. Best.

58. PC Guaranty Fund Assessments: 1978-2010
Correlation = 81%.
Source: A.M. Best Company, National Conference of Insurance Guaranty Funds.

59. LH Guaranty Fund Assessments: 1988-2010
Source: A.M. Best, National Organization of Life and Health Insurance Guaranty Associations.

60. PC insurers beat the S&P during crisis, life insurers did not.
US Insurance Stock Indices vs. S&P 500
PC insurers beat the S&P during crisis, life insurers did not.

61. Insurer Leverage & Solvency: Conclusions
US regulated insurance companies are highly solvent
Insolvency rates are low
Guaranty fund costs are low
Financial crisis had little impact on insurer insolvencies
Life insurers give some cause for concern
More highly leveraged than PC but about same as banks
More interconnected than PC insurers (susceptibility to affiliates)
LH stocks harder hit by crisis than PC stocks
Inter-connectedness does not pose serious solvency threat for PC insurers based on past experience
Monolines (insurers of bonds) are a different story
Not traditional insurance

62. Contributing Factors: Liquidity Risk and Asset-Liability Mismatches62

63. Liquidity Risk Danger signals for life insurance industry
ABS/MBS = 194% of surplus (only 27% of surplus for PC insurers)
Privately placed bonds = 204% of surplus (only 10% of surplus for PC insurers)
But, life insurers have significant cash from operations
43.8% of surplus
28.1% of benefit payments
Conclusion: Liquidity risk exists from mortgage-backed securities and private placements for life but not PC insurers – partly offset by cash flow

64. Maturity Mismatches
Asset and liability maturities tend to be long-term for insurers (in absolute terms and relative to banks)
Property-casualty liabilities not “putable”
Must experience a loss and file a claim to collect
Most life insurance long-term and not putable
Exceptions: cash value life insurance, variable life, and variable annuities
However, usually a penalty for early surrender
Conclusion: Maturity mismatch not a problem but some putability risk for life insurance

65. Contributing Factors: Complexity65

66. Complexity AIG prime example of complexity
Complicated group structure
Geographically dispersed
Complex, new financial products
Large multi-national insurers common in insurance industry
Life insurance more complex than PC
Most life products have embedded derivatives
Conclusion: Complexity is a problem for the large, multi-product, multi-national insurers

67. Contributing Factors: Government Policy and Regulation67

68. Do Guaranty Funds Create Moral Hazard?
In theory, mis-priced guaranty fund coverage provides incentives for excessive risk-taking
In practice, guaranty funds do not seem to be a problem
No solvency crisis for US regulated insurance companies – now or during Financial Crisis
Guaranty fund assessments have been very low
Possible rationale:
Risk-based capital (introduced in 1994) blunts insurer incentives for excessive risk-taking
GF protection is incomplete (low maximums, etc.)

69. Regulation of Complex Multi-Nationals
Generally, complex multi-national financial service firms lead to gaps in regulation
No one regulator has responsibility for entire firm
Different national regulators have responsibility for nationally domiciled subsidiaries
Banking and insurance subs may be regulated by different organizations
At least in US, regulation of insurers mostly at the individual insurer rather than the group level
Conclusion: Better supervision needed for insurance groups and multi-national financial services firms

70. Conclusions: Does Insurance Pose Systemic Risk?70

71. P-C Insurance May Not Create Systemic Risk
“Runs” are not possible
To obtain funds, it is necessary to have a claim
Unlike bank deposits, which are instantaneously “putable”
Insurance not involved in liquidity creation, payments system, or business/consumer lending
Insurers hold only small proportion of total invested assets in the economy
Insurance claim payments are not a major financial asset for any economic sector
However, intra-sector reinsurance exposure could cause “reinsurance spiral” spreading across the P-C industry
Not clear if this would be a true systemic event, i.e., not likely to affect other financial institutions or the real economy

72. Does Life Insurance Pose Systemic Risk?
Why LI may be systemically risky
Life insurance investment products are susceptible to “runs” (withdrawals and/or suspension of premium payments/annuity considerations)
Life insurers are thinly capitalized in comparison with P-C insurers, but similar to banks
Life insurers hold large amounts of ABS/MBS and private placements relative to surplus
Insurance guaranty fund system probably not adequate for a major run or liquidity crisis
Life insurers owned by banks (and vice versa) could add to fragility of banking system

73. Does Life Insurance Pose Systemic Risk?
Why LI may NOT be systemically risky
Life insurance sector not involved in payments system, liquidity creation, credit creation, etc.
Life insurers own only small proportion of stocks and bonds in the economy (about 6%)
Life insurance is a small proportion of household financial assets (about 3%)
Many substitutes exist for life insurance policies
Life insurers not major employers (< 2% of non-farm civilian labor force)
Disappearance of the entire sector would be tragic but sustainable

74. Systemic Risk In Insurance: Non-Core Activities
As AIG debacle shows, the main systemic risk posed by the insurance industry comes from insurer participation in “banking” activities, e.g., credit default swaps (CDS) and other derivatives
Swiss Re data shows that insurers and reinsurers accounted for 33% of CDS market in early 2000s
As with AIG, most insurers are not adequately capitalized to sustain large CDS meltdown
Insurance groups should required to increase transparency of CDS operations
Tighter regulation of leverage at non-insurance subs

75. Overall Regulatory Implications
Regulators need to improve capabilities in group supervision
Regulation of non-insurance subsidiaries to head off future AIG-type crises
Improved measures of group level solvency risk
Regulators need to improve international coordination of insurance supervision for multi-national insurers
Coordinate national regulators & the International Association of Insurance Supervisors

76. Hua Chen, J. David Cummins, Krupa Viswanathan, and Mary A. Weiss
Systemic Risk and the Interconnectedness Between Banks and Insurers: An Econometric Analysis
Hua Chen, J. David Cummins, Krupa Viswanathan, and Mary A. Weiss
Presented at: 2013 CICIRM
Kunming, China
July 18, 2013
Copyright J. David Cummins, 2013, all rights reserved. Not to be reproduced without author’s permission. 1 1 76 1 1

77. Prior Literature: Insurers & Banks
Two Prior Papers measure systemic risk in banking and insurance using market data
Billio et al. (2012) – monthly stock returns
Hedge funds, brokers, banks, and insurance companies
Principal components and linear Granger causality test
Conclusion: All four sectors have become highly interrelated in the past decade, increasing the level of systemic risk in the banking and insurance industries
Acharya et al. (2010) – daily stock data
Systemic expected shortfall (SES) – propensity to be undercapitalized when the system as a whole is undercapitalized
Conclusion: 9 insurers among the top 50 systemic financial institutions

78. “Are insurers instigators or victims of systemic risk?”
Purpose of Our Paper
Develop and implement a robust systemic risk measure for insurance
Investigate interconnectedness between banking and insurance during financial crisis
We use CDS quotes and intra-day equity returns to estimate systemic risk in the insurance and banking industries
“Are insurers instigators or victims of systemic risk?”

79. Purpose II Our systemic risk measure relies on
Daily-frequency market price data for CDS (Markit)
Intra-day trading data on stock prices (TAQ)
Systemic risk measure is risk-neutral, forward-looking and economically intuitive
Direction of interconnectedness investigated
Linear and non-linear Granger causality
Correcting for heteroskedasticity

80. Contribution to Literature
First paper to use data on CDS spreads and intra-day stock prices to study systemic risk for the insurance industry
Different econometric methodology than Billio et al. (2012) and Acharya et al. (2010)
New evidence on whether insurers are victims or sources of systemic risk

81. Measuring Systemic Risk
Two major components that determine risk profile of sample firms:
Probability of default of each insurer (based on CDS premiums – Markit.com)
Default correlation (estimated indirectly from underlying equity return correlation -- TAQ)
Measure of systemic risk uses portfolio credit risk methodology (developed by Huang et al., 2009)

82. Distress Insurance Premium (DIP)

83. A Measure of Systemic Risk
Estimate forward-looking, risk-neutral indicator of systemic risk of insurance industry:
“price of insurance against financial distress (DIP)”
Define financial distress by choosing a threshold (e.g., 15%) such that the ratio of portfolio credit losses to total liabilities of the insurance sector is equal to or above threshold

84. A Measure of Systemic Risk II
Construct a hypothetical portfolio
Consists of debt instruments issued by the sample banks/insurers, weighted by the liability size of each firm.
Conduct Monte Carlo simulation (Tarashev and Zhu 2008)
Probability of joint default (PD)
Loss given default (LGD)
Systemic risk measure: the price of insurance against financial distress

85. A Measure of Systemic Risk III
Systemic risk measure is calculated as risk-neutral expectation of portfolio credit losses that reach at least a minimum share (15%) of sector’s total liability
= systemic risk measure for insurance industry
Lt = portfolio credit losses
TLt = total liability of insurance sector at time t

86. A Measure of Systemic Risk IV
Similar estimation procedure is performed for firms in banking sector to obtain
used to analyze degree of interconnectedness between insurance and banking industries.

87. A Measure of Systemic Risk V
Advantage of method is that does not require large sample of firms
Huang et al. (2009) – 12 banks
Conclusions apply to relatively large firms since they have traded CDS
Large insurers have lower default probabilities than smaller insurers so results apply more strongly to small insurers

88. Granger Causality Tests
Testing Granger causality involves using F-tests to determine whether lagged information on a variable X provides any significant information about a variable Y in the presence of lagged Y.
If not, then X does not Granger-cause Y
Linear Granger causality tests conducted first
Then do nonlinear Granger causality tests
Nonlinear Granger causality test uses the residuals from the linear causality test
Then do Hiemstra-Jones (HJ) Test on residuals

89. Data and Systemic Risk Measures
Sample Selection
Sample of banks and insurers (Markit, SIC code)
Check whether the firm is publicly traded on a US exchange (TAQ)
Focus on 5-year, Senior, No Restructuring CDS Quotes on Friday
Fill in missing values
Use other quotes on the same day for conversion
Trace back one (two,…, five) day(s) before
Interpolation
Determine a common time period
Our sample: 11 insurers and 22 banks with CDS quotes over the period Feb 2002 to May 2008

90. Sample Firms

91. Average Probability of Default
Default probability begins to spike in 3rd quarter of 2007.

92. Systemic Risk Measure
After measuring probabilities of default and asset return correlations, the systemic risk measure can be computed for each week
Systemic risk measure represents a weekly price of insurance against distressed losses over the following three months.
To make comparisons, unit price of insurance = ratio of nominal price to total liabilities of sample firms in each sector

93. Linear Granger Causality Tests
Distress Insurance Premiums
are not stationary
Differenced time series are stationary
Linear causality tests are performed on the differenced series

94. Linear Granger Causality Tests
The results imply that systemic risk of insurers Granger-causes systemic risk of banks
Also, systemic risk of banks Granger-causes systemic risk of insurers
However, results of BDS tests indicate that nonlinearities are present in the univariate systemic risk measures for both banks and insurers
Therefore, we must conduct nonlinear Granger causality tests
BDS = Brock-Dechert-Scheinkman.

95. Control for Conditional Heteroscedasticity
If conditional heteroskedasticity exists, causality test results can be biased
Residuals from Granger-causality tests reveal
Little autocorrelation
Conditional heteroskedasticity exists
Therefore, use GARCH (1,1) model to assess whether the bi-directional causality changes
Re-do linear and nonlinear Granger tests using GARCH

96. Non-Linear GARCH Models: Main Results
Nonlinear effect of insurers on banks is highly significant at 1 lag
Significance fades after 3 lags
Banks in contrast have persistent predictive power on insurers up to 5 lags
Systemic risk of banks has longer duration of impact on insurers
Impact is also stronger than insurer effect on banks

97. Interconnectedness: Stress Testing
Stress testing conducted to study the impact of systemic risk movements in the banking sector on the insurance sector and then vice versa
A hypothetical shock in systemic risk of banking sector is fed into GARCH regression to generate future dynamic movements of systemic risk in the banking and insurance sectors
Shocks of 5%, 10%, 15% and 20% are applied
Systemic risk of insurance sector fed into GARCH model as well to generate future dynamic movements of systemic risk

98. Inter-Sector Impact of 20% Systemic Shock

99. Non-Linear Tests: Conclusions
Banks create economically significant systemic risk for insurers but not vice versa
Based on linear and non-linear Granger causality tests correcting for heteroskedasticity
Therefore, insurers seem to be victims of systemic risk rather than instigators
Banks are instigators of systemic risk

100. Systemic Risk: Policy Implications
Regulators should focus on banks to prevent/ameliorate systemic shocks from banks
Regulators should focus on non-core rather than insurance activities of large insurers
Insurance regulators should focus on mitigating effect of shocks from banks (e.g., investment restrictions and tighter capital requirements for life insurers)

101. Thank you!

102. Further Information
American International Group, 2009, AIG: Is the Risk Systemic? Powerpoint presentation (New York).
De Bandt, Olivier and Philipp Hartmann, 2000, Systemic Risk: A Survey (Frankfurt, Germany: European Central Bank).
Geneva Association, 2010, Systemic Risk in Insurance: An Analysis of Insurance and Financial Stability (Geneva, Switzerland).
Group of 10, 2001, Report on Consolidation in the Financial Sector
Harrington, Scott E., 2009, “The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation,” Journal of Risk and Insurance 76:
Kaufman, George G., 1996, “Bank Failures, Systemic Risk, and Bank Regulation,” The CATO Journal 16:
Kaufman, George G., 2000, “Banking and Currency Crises and Systemic Risk: Lessons from Recent Events,” Federal Reserve Bank of Chicago Economic Perspectives 24: 9-28.
Swiss Re, 2003, Reinsurance – A Systemic Risk, Sigma No. 5/2003 (Zurich, Switzerland).
World Economic Forum, 2009, Global Risks 2009 (Geneva, Switzerland).
Cummins, J. David and Mary A. Weiss, 2012, “Systemic Risk and the U.S. Insurance Sector,” working paper, Temple University, Philadelphia.

103. My Research on Systemic Risk
Cummins, J. David and Mary A. Weiss, 2013, “Systemic Risk and the Insurance Industry,” forthcoming in Georges Dionne, ed., Handbook of Insurance, 2d ed. (Springer).
Chen, Hua, J. David Cummins, Krupa Viswanathan, and Mary A. Weiss, 2013, “Systemic Risk and the Inter-Connectedness between Banks and Insurers: An Econometric Analysis,” forthcoming, Journal of Risk and Insurance.
Chen, Hua, J. David Cummins, Krupa Viswanathan, and Mary A. Weiss, 2013, “Systemic Risk Measures in the Insurance Industry: A Copula Approach,” working paper, Temple University, Philadelphia
Cummins, J. David and Mary A. Weiss, 2013, “Systemic Risk and the Regulation of the U.S. Insurance Industry,” working paper, Temple University, Philadelphia.
Cummins, J. David and Mary A. Weiss, 2012, “Systemic Risk and the U.S. Insurance Sector,” working paper, Temple University, Philadelphia.
To obtain the papers, please

104. Systemic Risk: Reinsurance Counterparty Exposure
104

105. Reinsurance Exposure: Recoverables from Non-Affiliates, P-C Insurers
Reinsurance Recoverables/Policyholders Surplus From Non-affiliated Reinsurers
Ceded paid losses
Ceded unpaid losses
Ceded IBNR
Ceded unearned premiums
Ceded commissions
Minus funds held from reinsurers
Normal range: 50% to 150%
Un-weighted average for groups = 43% (2008)

106. Reinsurance Exposure: Ceded Reinsurance Leverage from Non-Affiliates
Ceded Reinsurance Leverage From Non-Affiliated Reinsurers/Policyholders Surplus
Reinsurance recoverables
Ceded balances payable
Ceded premiums written
Minus funds held from reinsurers
Normal range: Component of gross leverage. Gross leverage range is 5 to 7
Un-weighted average for groups = 70% (2008)

107. Reinsurance Recoverables/Surplus: Groups
For 26% of groups, non-affiliate recoverables > 50% of surplus
Reinsurance recoverables from non-affiliated reinsurers, including ceded paid losses, unpaid losses, IBNR losses, unearned premiums and commissions less funds held from reinsurers. Source: Best’s Key Rating Guide, Data are for 2008.

108. Reinsurance Receivables/Surplus: Industry
Non-affiliate receivables = 28% of industry surplus in 2008.
Reinsurance recoverables from non-affiliated reinsurers, including ceded paid losses, unpaid losses, IBNR losses, unearned premiums and commissions less funds held from reinsurers. Source: Best’s Key Rating Guide, Data are for 2008.

109. Reinsurance Leverage/Surplus: Groups
For 30% of groups non-affiliate leverage > 75% of surplus.
Reinsurance recoverables, ceded balances payable, and ceded premiums written less funds held divided by policyholders surplus. Source: Best’s Key Rating Guide, Data are for 2008.

110. Reinsurance Leverage/Surplus: Industry
Non-affiliate leverage = 40% of industry surplus in 2008.
Reinsurance recoverables, ceded balances payable, and ceded premiums written less funds held divided by policyholders surplus. Source: Best’s Key Rating Guide, 2009.

111. AIG: What Went Wrong?
111

112. US Life Insurers: 12 Month Change in Premiums (as of June 30, 2009)
Source: A.M. Best Company.

113. AIG: What Went Wrong?
AIG’s traditional insurance operations did not cause its meltdown
AIG’s problems came from:
Credit default swaps out of AIG Financial Products
(Supposedly) regulated by Office of Thrift Supervision
US insurance regulators had no jurisdiction
Securities lending program of life subsidiaries
Indicates need for more regulatory scrutiny in the future
US regulators do have jurisdiction if lending is out of regulated life insurance subsidiaries

114. AIG Revenues Before the Crash
12 months ending 12/31/2006.

115. AIG’s Credit Default Swaps
AIG sold CDS contracts, mostly to European banks (i.e., writing bond default insurance)
Banks were using the swaps to reduce regulatory capital, relying on AIGs overall credit rating (regulatory arbitrage)
AIG Financial Products had about $500 billion in CDS outstanding but virtually no capital
AIG’s models supposedly showed that losses on the CDS portfolio were virtually impossible
Losses due to model risk and managerial moral hazard

116. AIG’s Securities Lending Operation
AIG loans securities to broker dealer or bank (e.g., to cover short selling or for diversification)
Borrower posts collateral in form of cash or high quality securities
AIG reinvests the collateral and earns spread between yield on invested assets and yield on underlying securities
AIG had $82 billion in liabilities for securities lending as of year-end 2007, $69 billion in August 2008

117. AIG Securities Lending: What Went Wrong
Declines in value of mortgages and other assets in reduced value of reinvested collateral in securities lending programs
Many of the counterparties in the securities lending operation were the same institutions holding AIG CDS
As asset values declined, borrowers terminated the securities lending arrangement to
Improve liquidity
Reduce exposure to AIG’s credit risk
At the same time, AIG had to post additional collateral for the CDS transactions as underlying “insured” asset values declined
Essentially, a “run on the bank” by AIG’s counterparties

118. The Bailout: Payments to AIG Counterparties
Counterparty
CDS Trans.
Asset Lending
Total
Goldman Sachs
8.10
4.80
12.90
Societe Gen.
11.00
0.90
11.90
Deutsche Bank
5.40
6.40
11.80
Barclays
1.50
7.00
8.50
Merrill Lynch
4.90
1.90
6.80
Bank of Amer
0.70
4.50
5.20
UBS
3.30
1.70
5.00
BNP Paribus
Others
14.70
11.60
26.30
49.60
43.70
93.30

119. US Insurer Assessments vs. AIG
Total US life and P-C assessments: $18.8 billion
Federal assistance to AIG (as of June 30, 2009): $136 billion
Not necessarily a net loss
But
Total assets of largest insurers: 2011
Met Life: $612.8 billion
State Farm: $135.2 billion
Source: A.M. Best Company, Harrington (2009).

120. Failure Costs: Met Life and State Farm (% of Life & PC Industry Assets, resp.)
Source: A.M. Best Company, author’s calculations.

121. What Is Systemic Risk Policy Trying to Prevent?
Runs on banks – traditional problem
Contagion – information asymmetries
Banking system collapse –
Continental bank
Correspondent bank collapse – counterparties
Jobs would be lost
Threat to settlement system
Threat to payments system
Fear that Infrastructure of short-term money market and OTC derivatives would not handle failure of significant counterparty
Cast doubt on soundness of other counter parties (e.g., case of Bear Stearns)
As time has gone on, it seems that we have evolved from specific concerns such as
Traditional concerns about runs on banks and
Contagion –due to information asymmetries
To some broader concerns about banking system collapse
In the case of Continental bank Correspondent bank collapse – counterparties
Jobs would be lost – (St Germain)
But some like Conover talked about unthinkable financial system collapse and Congressman St. Germain was concerned at that time about job loss
Threat to large dollar settlement system and network effects
Fear that Infra structure of short term money market and OTC derivatives would not handle failure of significant counter party and might cast doubts on the soundness of other counter parties (Bernanke on Bear Stearns)
Panic due to loss of confidence (Warsh)
Risks to system due to failure of “highly interconnected” firm
“Unpredictable consequences of a failure for broader financial system” (Geithner)
Reaction of counterparties of other firms that might come under future government control (Kohn on AIG). – only a psychologist and not an economist is qlualified to assess the risks

122. Systemic Risk Policy Is Trying to Prevent II
Panic due to loss of confidence
Risks to system due to failure of “highly interconnected” firms
“Unpredictable consequences of a failure for broader financial system”
Reaction of counterparties of other firms that might come under future government control
AIG was large, complex and interconnected whose failure would impose losses on counterparties and also endanger the entire world’s financial sector (Bernanke-Morehouse University)
As time has gone on, it seems that we have evolved from specific concerns such as
Traditional concerns about runs on banks and
Contagion –due to information asymmetries
To some broader concerns about banking system collapse
In the case of Continental bank Correspondent bank collapse – counterparties
Jobs would be lost – (St Germain)
But some like Conover talked about unthinkable financial system collapse and Congressman St. Germain was concerned at that time about job loss
Threat to large dollar settlement system and network effects
Fear that Infra structure of short term money market and OTC derivatives would not handle failure of significant counter party and might cast doubts on the soundness of other counter parties (Bernanke on Bear Stearns)
Panic due to loss of confidence (Warsh)
Risks to system due to failure of “highly interconnected” firm
“Unpredictable consequences of a failure for broader financial system” (Geithner)
Reaction of counterparties of other firms that might come under future government control (Kohn on AIG). – only a psychologist and not an economist is qlualified to assess the risks

123. Preview of Results
After adjustment for heteroscedasticity, impact of banks on insurers found to be stronger and of longer duration than impact of insurers on banks
Stress tests indicate that banks create significant systemic risk for insurers & not vice versa
Insurers are primarily victims rather than instigators of systemic risk

124. Measuring Systemic Risk: Methodologies
Huang et al. (2009): Distress Insurance Premium
Acharya et al (2010): Systemic Expected Shortfall
Adrian and Brunnermeier (2010): CoVAR
Zhou (2010): Multivariate extreme value theory
Billio et al (2012): Principal Components, Causality tests
Insurers can be a source of systemic risk to some extent.

125. Nonlinear Granger Causality Tests II
Diks and Panchenko (2005, 2006)
HJ test could produce spurious results in the presence of conditional heteroskedasticity
Ross (1989), Andersen (1996)
Volatility of a time series can measure the rate of information flow.
Use the GARCH model to assess whether the bi-directional causality changes.

126. Sample Firms II
Of 11 insurers, 8 are classified as property-liability insurers
Of remaining three,
Lincoln National had only life-health operations
MetLife group has property-liability operations
Prudential divested property-liability operations, but owned these operations at the beginning of sample.