Since the collapse of global financial markets in 2008, politicians and regulators have been watching banks closely for signs they might trigger a new crisis. But there are other areas where systemic risk can be generated – areas that might have been overlooked.
In a new report, the International Monetary Fund (IMF) warned that a different sector could now be posing a grave risk of the financial system: the insurance business, long seen as a bastion of stability.
Chronically low interest rates are severely squeezing returns on capital, and volatile currency markets may threaten to set off chain reactions. According to the IMF, both the systemic importance of insurance and their vulnerability are sharply increasing. The insurance industry’s significance for global financial stability is still well below that of the banks, but it can no longer be overlooked.
While the IMF is now putting these dangers on the global map, they’ve long been a factor in Germany. The country’s financial regulator, BaFin, has already warned of these risks. It says insurance companies will have to do a better job of adapting to a long period of low interest rates.
“Anything else would simply be negligent,” was the clear message in February from Frank Grund, BaFin’s chief executive director of insurance and pension funds supervision.
“Insurance companies will have to adapt to a long period of low interest rates. Anything else would simply be negligent.”
Germany is home to some of the world’s largest insurers and re-insurers, led by names such as Allianz and Munich Re. While both top firms remain profitable for now, there are signs that their business models are struggling in the current era of historically low interest rates. Warren Buffett, the famed U.S. investor, cut his stake in Munich Re at the end of last year.
The risks are piling up: On the orders of BaFin, in the last year alone German life insurance companies have set aside €10 billion, or $14 billion, to cover commitments made during the era of high interest rates – commitments they are making a loss on today. That brings the total they have set aside for this since 2011 to €32 billion.
Mr. Grund is on the record as foreseeing further “significant increases” in this requirement, while admitting this could bring some insurance companies to the edge of their financial capacity. Europe’s insurance regulator has expressed similar worries about the looming bankruptcy of many insurers on the continent.
Despite these concerns, progress has been slow in broadening ideas about which institutions can be seen as a “systemic risk” to the global financial industry. Gaston Gelos, head of IMF’s Global Financial Stability Division and one of the main authors of the new IMF report, suggested this needs to change. He emphasized the increasing risk associated with insurance companies: “In general, we favor considering non-bank institutions as systemically important.”
The industry itself is resisting. Recently, a lawsuit by the giant American insurance company MetLife succeeded in removing its classification as “systemically important,” in other words, “too big to fail.”
The Financial Stability Oversight Council, or FSOC, brings together all the major American financial regulators, including the Federal Reserve. The FSOC had classified a number of non-bank financial institutions as systemically important. This included MetLife, as well as its fellow large insurers AIG and Prudential, and the financial arm of electronics giant General Electric.
For this reason, the MetLife case is not an isolated one for the U.S. federal government. It thinks classifying non-bank institutions as systemically important is crucial in order to keep so-called “shadow banks” within their regulatory grasp. No wonder the U.S. authorities are fighting the court decision.
The IMF does not hold insurance companies directly responsible for the new stability problems. Its report notes that insurers tend to be more cautious in their investment patterns, which is partly down to new accounting standards. But risks are nonetheless increasing, largely because of a new tendency for capital markets to fluctuate in unison with each other.
Market movements within any one class of investments, like stocks, are increasingly statistically correlated. These correlated movements are increasingly common within other investment classes, like corporate bonds. This means any shock to the global financial system could hit a large number of insurers at the same time. Were this to happen, the whole system could be put at risk, said the IMF report.
In addition, ongoing ultra-low interest rates are making it difficult for insurance companies to make enough returns on their capital. According to Mr. Gelos, this brings the model of life insurance policies with guaranteed minimum returns under threat. The model has historically been particularly popular in Germany. “Insurance companies are going to have to find a way to make customers bear more of the risk,” Mr. Gelos warned.
European insurance regulatory EIOPA fears low interest rates could force companies to take significantly greater risks. Since capital now available to insurance companies cannot easily make the same returns as previously, life insurance companies, above all, may be “forced into a hunt for higher returns.”
“Global financial interdependence has its advantages, but there are risks involved too.”
According to the IMF, the insurance industry is not the only growing risk to global financial stability. The ever-closer interdependence between industrial economies and emerging markets could also become a systemic instability. The Fund warns of feedback effects which could see contagious crises spreading worldwide.
“International interdependence means European and American politicians with responsibility for the economy need to pay more attention to developments in emerging economies,” said Mr. Gelos.
The globalization of financial markets is continuing rapidly. It has never been so easy for investors to distribute capital across different continents. Much more frequently then before, investors in industrialized countries are buying stocks and bonds from emerging nations. This diversification may be intended to minimize risk, but it can also lead to dramatic capital movements, which can help to spread crises.
“Global financial interdependence has its advantages, but there are risks involved too,” Mr. Gelos said. “In global terms, the advantages outweigh the risks. For individual countries, the cost-benefit ratio depends on a number of factors, including a country’s level of development and the strength of its institutions.”
One way or another, it is crucial to better manage the risks of increasing interdependence. This should mean increased cooperation between industrialized countries and emerging nations, for example through G20 summits, he added.
Moritz Koch has been Handelsblatt’s Washington correspondent since 2013. Frank Wiebe is a New York correspondent for Handelsblatt, covering finance policy. To contact the authors: email@example.com and firstname.lastname@example.org.