Analysis of FSIs for Insurance
Insurance is an important and growing part of the financial sector in virtually all developed and in many emerging economies; consequently, insurance sector soundness is important.10 Insurers help to allocate risks and to mobilize long-term savings (especially retirement savings) by spreading financial losses across the economy. Insurance companies facilitate economic activity in sectors, such as shipping, aviation, and the professional services that are particularly reliant on insurance. The insurance companies can help to promote risk-mitigating activities through their incentives to measure and monitor the risks to which they are exposed. Finally, insurance companies help promote stability by transferring risk to entities better able to evaluate, monitor, and mitigate those risks through specialization.
The risk profiles of insurers and banks differ. Insurance companies generally are exposed to greater volatility in asset prices and face the potential for rapid deterioration in their capital base. Insurance companies typically have liabilities with longer maturities and assets with greater liquidity than banks have, thus enabling the insurance companies to play a larger role in long-term capital markets. Life insurers often have significantly higher exposure to equities and real estate and lower exposure to direct lending than do banks. In some countries, insurers offer products with guaranteed returns, further exacerbating risks for life insurers.
The importance of the insurance sector for financial stability has increased recently because of intensified links between insurers and banks, thereby increasing the risk of contagion. Those links can include cross-ownership, credit-risk transfers, and financial reinsurance. Financial deregulation has caused insurers to diversify into banking and asset management products, thus exposing them to additional risk by making their liabilities more liquid. Insurers have also increased their exposure to equities and complex risk management products in response to deregulation and declining yields on fixed-interest products.
Assessing the soundness of the insurance sector requires good understanding of linkages among, and determinants of, the various financial soundness indicators for the insurance sector discussed in chapter 2. In addition, the analysis of those indicators should be supplemented by information on the quality of risk management in the insurance industry, which will draw on the assessment of observance of relevant supervisory standards (see discussion that follows). Capital adequacy can be viewed as the key indicator of insurance sector soundness. However, analysis of capital adequacy depends on realistic valuation of both assets and liabilities of the insurance sector. Compared with banking, asset side risks for the insurance sector are similar, but liability side risks depend on different factors, such as demographic and sectoral developments. Assessing the stability of the insurance sector should take into account the size and growth of the sector, the importance of banking – type and asset-management-type products, the structure of the industry (including the relative importance of the life sector), and the strength of linkages to the banking sector.
Data quality may be an issue because many countries lack the actuarial expertise, supervisory authority, or capacity to collect sufficient information.
The analysis and interpretation of soundness indicators should draw on an evaluation of the observance of Insurance Core Principles issued by the International Association of Insurance Supervisors (IAIS 2003) (see also chapter 5). This set of principles provides information on the effectiveness of supervision, the structure and characteristics of companies in the sector, and other useful qualitative information that is not always captured by financial ratios.11 In particular, the specifics of supervisory and regulatory environment affect asset composition, as well as the mix of risks, and should be taken into account in interpreting insurance FSIs.