May 14, 2014
When Insurance is Systemically Risky
Posted by Erik Gerding

Dan and Steven Schwarcz have an insightful new article, Regulating Systemic Risk in Insurance (forthcoming Univ. of Chicagao Law Review).  The potential systemic risk in the insurance industry became front page news after AIG (see here for an essay questioning the AIG bailouts).  It has continued to simmer; the Financial Stability Oversight Council designated both AIG and Prudential as non-bank SIFIs (systemically important financial institutions).  One criticism of this desgination is that it may lead to bank-style regulations being imposed on these firms even though the risks they pose are different in kind from banks (e.g., insurance firms typically don't engage in maturity transformation).

So how might insurance firms pose systemic risk concerns?  Schwarcz fils and per focus less on size and Too-big-to-fail, and more on risk correlations.  This insight is welcome: the Beltway obsession with size has obscured other dangers, such as herd behavior and correlated risk exposures.    

What should be done?  Schwarcz and Schwarcz argue for a greater federal role in regulating insurance.  Yet they chose to focus less on FSOC and more on an expansive role for one of Dodd-Frank's less well-known innovations, the Federal Insurance Office.  Their abstract is after the jump...

Schwarz & Schwarcz abstract:

As exemplified by the dramatic failure of American International Group (AIG), insurance companies and their affiliates played a central role in the 2008 Global Financial Crisis. It is therefore not surprising that the Dodd-Frank Act – the United States’ primary legislative response to the crisis – contained an entire title dedicated to insurance regulation, which has traditionally been the responsibility of individual states. The most important of these insurance-focused reforms in Dodd-Frank empowered the Federal Reserve Bank to impose an additional layer of regulatory scrutiny on top of state insurance regulation for a small number of “systemically important” insurers, such as AIG. But in focusing on the risk that an individual insurer could become too big to fail, this Article argues that Dodd-Frank largely overlooked a second, and equally important, potential source of systemic risk in insurance: the prospect that correlations among individual insurance companies could contribute to or cause widespread financial instability. In fact, the Article argues that there are often substantial correlations among individual insurance companies with respect to both their interconnections with the larger financial system and their vulnerabilities to failure. As a result, the insurance industry as a whole can pose systemic risks that regulation should attempt to identify and manage. Traditional state-based insurance regulation, the Article contends, is poorly adapted at accomplishing this given the mismatch between state boundaries and systemic risks and states’ limited oversight of non-insurance financial markets. As such, the Article suggests enhancing the power of the Federal Insurance Office – a federal entity currently primarily charged with monitoring the insurance industry – to supplement or preempt state law when states have failed to satisfactorily address gaps or deficiencies in insurance regulation that could contribute to systemic risk.

Financial Crisis, Financial Institutions | Bookmark

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