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Introduction: symposium on convergence, interconnectedness, and crises: insurance and banking.

A conference on Convergence, Interconnectedness, and Crises: Insurance and Banking was held at Temple University in Philadelphia from December 8 to 10, 2011. The conference was cosponsored by Temple University's Advanta Center for Research on Financial Institutions, SCOR Group, The Canada Research Chair in Risk Management, HEC Montreal, CIRPEE (Quebec, Canada), and The Journal of Risk and Insurance. Seventeen research papers and two keynote addresses were presented at the conference, and six papers from the conference are published in this symposium. The conference key note addresses were delivered by Denis Kessler, Chairman and CEO of SCOR Group, and Andrew W. Lo, Harris & Harris Group Professor of Finance, MIT Sloan School of Management.

The Financial Crisis of 2007-2010 revealed significant interrelationships both within and between the insurance and banking industries that contributed significantly to the magnitude of the crisis and the resulting government bailout. The need for additional research on interconnectedness provided the motivation for the Conference. The objective was to help minimize or avoid future crises through careful scholarly explorations of these interconnections. Researchers from around the world spent 3 days delving into numerous insurance and banking topics, ranging from systemic risk to implications of financial services mergers to extreme correlations within the insurance industry.

The introductory article in this symposium, by Denis Kessler, is based on his keynote speech at the Conference. In his article, Kessler argues that the (re)insurance industry is not a significant source of systemic risk. Kessler emphasizes that (re)insurance failures are very rare, orderly, long-term processes, unlike banking crises, which are short term and associated with panics. He points out that a failing (re)insurance company does not terminate its contracts overnight but continues to settle claims. Thus, (re)insurance failures do not require sudden liquidation of assets and liabilities, as in the case of many banking failures. One reason that banks are susceptible to systemic risk is the interbank lending market, where risk is strongly concentrated due to a network of very short-term, bilateral exposures. In contrast, the structure of the (re)insurance market is hierarchical, in the sense that primary insurers cede a single risk to many other reinsurers, which in turn often cede it to different retrocessionnaires. In contrast to retail bank deposits and wholesale market bank funding, (re)insurance reserves are not instantaneously puttable and thus cannot be redeemed on demand by policyholders. Also unlike banks, which tend to borrow short term and lend long term, (re)insurers' asset and liability maturities tend to be well matched. Therefore, regulators should resist the temptation to put (re)insurers in the same category as banks and other financial institutions. Neither insurers nor reinsurers create significant systemic risk. Therefore, Kessler argues, designating (re)insurers as systemically important financial institutions (SIFIs) would reduce insurers' and reinsurers' profitability at the expense of solvency.

The second article in the symposium is a macro-overview analysis of systemic risk in the insurance industry by J. David Cummins and Mary A. Weiss. Their article examines the potential for the U.S. insurance industry to cause systemic risk events that spill over to banking or other segments of the economy. They examine primary indicators of systemic risk as well as contributing factors that exacerbate vulnerability to systemic events. The evaluation of systemic risk is based on a detailed financial analysis of the insurance industry, its role in the economy, and the interconnectedness of insurers. Insurers are shown to have very low default risk and low susceptibility to financial crises. However, life insurers have higher leverage and more exposure to asset-backed securities and illiquid privately placed bonds than property-casualty (P-C) insurers. The primary overall conclusion is that the core activities of U.S. insurers do not pose systemic risk, where core activities are defined as those functional areas relating to provision of traditional insurance-type products. However, life insurers are vulnerable to intrasector crises, and both life and P-C insurers are vulnerable to reinsurance crises. The researchers conclude that noncore activities such as financial guarantees and derivatives trading may cause systemic risk and that interconnectedness among financial institutions has grown significantly in recent years. To reduce systemic risk from noncore activities, regulators need to continue efforts to strengthen mechanisms for insurance group supervision. Improved international coordination of regulation is also needed to regulate multinational (re)insurance and financial organizations.

The financial crisis severely depleted the equity capital of many financial institutions, resulting in federal bailouts for many institutions. However, with the exception of American International Group and a handful of other large insurers, little federal bailout money was directed to the insurance industry. Thomas R. Berry-Stolzle, Gregory P. Nini, and Sabine Wende analyze the reaction of the U.S. life insurance industry to the capital depletions resulting from the crisis. Although the financial crisis and subsequent recession generated sizable operating losses for U.S. life insurers, the consequences were far less significant than for other financial intermediaries. The ability to generate new capital through external issuance and dividend reductions permitted life insurers to quickly restore healthy levels of equity capital following the onset of the crisis. The authors utilize this experience to examine the causes and consequences of external capital issuance by U.S. life insurance companies. They show that insurers generated new capital both to support the growth of new business and to replace capital depleted by operating losses. This second channel is particularly important during macroeconomic recessions. Notably, they do not find any evidence that insurers had difficulty generating new capital, unlike other financial service providers that required large amounts of public support. For life insurers, what changed following the financial crisis was the demand to raise external capital, but the supply of external capital appears to have remained constant. Hence, life insurers were remarkably resilient in confronting the crisis. This resiliency has significant implications for federal regulators considering the possible designation of life insurers as SIFIs as well as for state regulation of these firms.

Daniel Rosch and Harald Scheule develop a model for default and correlation of rated mortgage-backed securities and home equity loan securitizations. The modeling is motivated by the global financial crisis (GFC), which exposed financial institutions to severe unexpected losses from mortgage securitizations and derivatives. Financial markets were surprised by the high levels of impairment rates and massive downgrades of seemingly high quality (e.g., AAA-rated) mortgage-backed securities in 2007 and 2008. The crisis thus exposed the shortcomings of the securitization rating models applied by credit rating agencies. Rosch and Scheule investigate two properties of ratings-based risk models: (1) the large exposure of securitized tranches to systematic risk, and (2) the instability or uncertainty of model parameters. The article develops a simple model for securitization impairment risk based on a standard Merton-type approach, which allows for exposure of the tranches to a systematic "super-factor" that represents the economy. The model is empirically calibrated to a comprehensive panel data set of ratings and impairments of securitizations. The article shows the magnitudes of systematic risk exposure and parameter uncertainty. An out-of-sample forecasting analysis of the financial crisis shows that a simple approach addressing both issues would have been able to produce ranges for risk measures that cover realized losses. Systematic risk and parameter uncertainty may have not been included in impairment risk measures prior to the GFC. If they had been, the high impairment rates would not have been as "surprising" as observed.

Interconnectedness among firms is widely recognized as one of the primary indicators of the susceptibility of institutions and markets to systemic risk. Sojung (Carol) Park and Xiaoying Xie investigate reinsurance, which is the primary source of interconnectedness within the insurance industry. Despite the broad recognition that reinsurance interconnectedness may be a source of systemic risk in the insurance industry, little empirical work has been done to measure the extent of interconnectedness among insurers and reinsurers and to test the significance of this interconnectedness for systemic risk. Park and Xie's research remedies this gap in the literature by conducting two primary analyses of the U.S. P-C insurance industry: (1) They examine how rating agency downgrading of reinsurers affects the credit risk of primary insurers and any accompanying impact on the stock prices of publicly traded insurance groups. (2) They provide scenario analyses of the impact of reinsurer failure(s) by examining ratings downgrades and insolvencies resulting from the collapse of leading world reinsurers. The study takes advantage of unique disclosure requirements in the regulatory annual statements filed by insurers with the National Association of Insurance Commissioners, where U.S. licensed insurers must disclose by counterparty name and transaction volume all ceded reinsurance transactions with both domestic and foreign reinsurers. Park and Xie find that the downgrade of reinsurance counterparties increases the likelihood that primary insurers will be downgraded and that primary insurers' stocks react negatively to reinsurer downgrades. However, despite the close interconnectedness, worst-case scenario analyses show that the likelihood of systemic risk caused by reinsurance transactions is relatively small for the U.S. P-C insurance industry.

The final article in this symposium, by Hua Chen, J. David Cummins, Mary A. Weiss, and Krupa Viswanathan, provides an econometric analysis of the interconnectedness between banks and insurers. Specifically, the authors seek to determine whether insurers (banks) pose a statistically or economically significant source of systemic risks to banks (insurers). They estimate a forward-looking, risk-neutral measure of systemic risk in the insurance industry, the distress insurance premium. They estimate two major components that determine the risk profile of their sample portfolio of insurers and banks--the probability of default for each institution and the default correlation. The probabilities of default are estimated using data on credit default swap (CDS) premiums, and default correlations are estimated indirectly from the underlying equity return correlations using data on intraday stock prices. Next, they implement their measure of systemic risk utilizing a portfolio credit risk methodology. The interconnectedness between banks and insurers (and vice versa) is then measured using linear and nonlinear Granger causality tests. Testing reveals that nonlinear effects are present and moreover that it is necessary to correct for conditional heteroskedasticity. The nonlinear effect of insurers on banks is highly significant at one lag, but that significance fades after lag 3. In contrast, banks have persistent predictive power on insurers. Stress testing reveals that shocks to the banking system have large, economically significant effects on insurers, whereas the effects of shocks from insurers on banks are negligible. The results are consistent with the notion that insurers tend to be victims of systemic risk rather than instigators. The results imply that regulators should focus on ameliorating the effects of banking shocks on the economy and that systemic risk regulators should focus on the banking rather than the core insurance activities of large insurers.

DOI: 10.1111/jori.12058

Symposium Editors/Conference Organizers:

J. David Cummins

Temple University

Philadelphia, PA

United States

cummins@wharton.upenn.edu

Georges Dionne

HEC Montreal

Montreal, Quebec

Canada

georges.dionne@hec.ca
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Author:Cummins, J. David; Dionne, Georges
Publication:Journal of Risk and Insurance
Geographic Code:1CQUE
Date:Sep 1, 2014
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