Introduction
This study concerns the role and impact of insurance and reinsurance activities in the development and maintenance of financial and economic stability.
Whilst the world has been influenced by numerous types of financial crisis, extant financial and management literature does not appear to have a widely accepted definition of financial crisis. Cristea, (2009), defines financial stability as follows:
"That distinctive feature of the financial system meant to deal with systemic shocks on a lasting basis and without generating major disturbances, to allot efficiently the financial resources within the economic department and to identify and manage efficiently the risks" (Cristea, 2009, p 11)
The world is still experiencing the aftermath of a financial crisis of huge proportions. The crisis originated in 2008 with the occurrence of the housing bust and the development of the subprime crisis in the United States, and thereafter spread, first to the advanced nations, and thence to the rest of the world (Blundell-Wignall, 2008). The role of the insurance and reinsurance sector in the financial crisis has repeatedly come up for debate and discussion (Blundell-Wignall, 2008). Whilst the financial crisis of 2008 and 2009 was primarily a banking crisis and did not entail serious threats to the solvency of the insurance sector, the working and profitability of insurance companies were nevertheless adversely affected (Schich, 2009).
The financial crisis affected the insurance industry, primarily on account of their investment portfolios, as also because of deterioration in real activity (Schich, 2009). Some focused exposures to market and credit risks were also revealed, and whilst insurers by and large appear to have resisted rather than increased downward pressures during the course of the crisis, some insurers do appear to have clearly augmented downward pressures (Schich, 2009). Investigations into the causes of the crisis also clearly reveal that safeguarding against systemic risks should incorporate assessment and mitigation of risks in the insurance sector (Schich, 2009).
This essay takes up the various functions and roles played by the insurance and reinsurance sectors in the broader economy that help in bringing about economic progress, with specific regard to their impact on the maintenance of financial stability. The role of these sectors in stabilising/ destabilising the economy during the financial crisis has been taken up for specific analysis.
Discussion and Analysis
Insurance, very simply, provides the economic service of distribution of risk in an economy. Individuals and organisations pay premiums to safeguard their lives and assets to insurance companies, which in return provide them with safety against events that could lead to potential economic losses (Swiss Reinsurance Company, 2010). With the overall probability of occurrence of such events being rare, insurance companies receive steady incomes, even as insured individuals and organisations obtain financial protection in the case of occurrence of specific events that could otherwise have disastrous economic consequences (Swiss Reinsurance Company, 2010).
Insurance companies help economies and societies in various other ways, e.g., by (a) protecting and safeguarding the investments of companies in large projects, (b) protecting road travellers from the consequences of accidents, and (c) freeing capital that is otherwise locked up for long term safety (Ward & Zurbruegg, 2003). Reinsurance on the other hand represents the insurance covers and protection measures that are purchased by insurance companies from other insurance companies, termed reinsurers, to manage their risks, by transferring such risks from insurers to reinsurers (Ward & Zurbruegg, 2003). Such reinsurance services are, as in the case of mainstream insurance services, provided against reinsurance premiums. Reinsurance companies have historically played economic and financial roles by smoothing out income fluctuations, transferring risks, financing growth, substituting equity capital, optimising tax outflows, and enhancing liquidity. As evident, all these functions help in cumulatively bringing about national and global financial stability (Ward & Zurbruegg, 2003).
With insurance and reinsurance companies having access to steady and substantial streams of cash flows, there basic business model is driven by their strategies for investments of these monies in return giving avenues (Henry, 2002). Insurance and reinsurance companies function as important and major investors in capital markets (Henry, 2002). Their investments in various types of financial securities and their mediation between their policy holders and financial markets help significantly in stabilising and supporting financial markets and national economies (Henry, 2002). Such companies have in the past stepped in on many occasions to bolster financial markets in times of financial crisis and thereby averted financial losses to millions of investors (Henry, 2002). Insurance and reinsurance companies are in many developing countries controlled by national governments and function as state tools for bringing about financial stability through sale and purchase of financial instruments in line with national policies and priorities (Henry, 2002).
With the funds of such companies being deployed extensively in financial instruments, they can often play major roles in the moderation and acceleration of movements of financial markets (Cristea, 2009). Their various investment portfolios often also include exposure to entities like equity and debt securities, share and debt securities of firms engaged in financial services, and subprime mortgage backed residential securities (Cristea, 2009). The valuation of some of these types of assets came under severe pressure during the worsening of the recent financial crisis and led to deterioration in the outlook for real activity. The recent price gains in markets have however provided relief to these investors (Schich, 2009).
Losses in valuation become apparent swiftly when such valuation is done on mark to market basis, even whilst the existence of liquidity premiums in market conditions that are stressed could well exaggerate the degree of losses that are finally realised on such securities (Schich, 2009). Insurance companies, like banks, need to mark their securities to market values. Whilst banks hold significantly larger shares of assets that are accounted with fair value principles, the existence of such assets with insurance companies has implications for the swiftness with which impairments in assets translate to losses (Schich, 2009).
Although insurance companies do have diversified portfolios with good quality investments and were as such protected during the initial periods of financial turbulence in 2008, they were subsequently significantly affected when the crisis spread to such levels that high quality securities were also substantially affected (Schich, 2009). Some insurance market segments have also been exposed because of their underwriting exposure (Schich, 2009). Insurance companies have engaged in issuance of various types of coverage for risks from (a) mortgage guarantee for lenders, (b) financial guarantees for structured financial products, and (c) liabilities of directors and officers (Blundell-Wignall, 2008). They have also been financially exposed because of their involvement with financial groups that have sold credit protection through credit default swaps (Cristea, 2009).
Financial experts state that insurance and reinsurance companies have by and large provided a number of stabilising elements during the financial crises of 2008 and 2009. They have not been forced to sell into declining markets because of liquidity, regulatory, leverage and other concerns (Schich, 2009). They have also continued to provide insurance in different sectors, thereby supporting economic activity and generating premium incomes. Such premium incomes have in turn been reinvested to some degree in financial assets and have thus helped in supporting and stabilising market prices (Schich, 2009).
Whilst these organisations have been able to absorb some of the financial shocks of the recent financial crisis, a number of areas of concern about their working have also surfaced in recent times (Cristea, 2009). The segments of the insurance sector, as well as the insurance companies, which have actively been engaged in activities associated with investment banking have been significant affected by downward rating and valuation pressures (Cristea, 2009). Such downward pressures have in turn worked to increase and augment the general downward forces in financial markets and increased financial instability (Cristea, 2009). The financial guarantee insurance sector provides an example of a segment that was significantly affected during the crisis and which could also have had systemic implications (Cristea, 2009).
The later downgrading of the diverse entities working in this sector resulted in the development of significant downward forces on the market values of the securities that were developed by these organisations and were included in the investment portfolios of various financial institutions (Cristea, 2009). Such activities also resulted in the development of financial and structural imbalances before the onset of the crisis (Cristea, 2009). Financial guarantors raised the credit ratings of intricately structured financial instruments, thereby making these products desirable even to more conservative investors, including a number of insurance companies (Cristea, 2009). The role of insurance firms as counterparties to commercial banks and investment institutions in credit default swap transactions allowed such banks and investment firms to hedge their credit risks (Schich, 2009). Such hedging, in turn, allowed them to continue to increase their securitisation actions, including the development of collateralised debt obligations with subprime mortgage-related debt and helped in the creation of the huge financial balloon that (Schich, 2009).
Whilst the insurance and reinsurance sectors have by and large played positive roles during the financial crisis, considerable concern has occurred on account of the expansion of financial groups that are dominated by insurance activity into other types of financial activities (Econbrowser, 2009, p 1). The negative impact of the functioning of one segment of such groups has spilled over into other segments and has threatened the very survival of such groups (Schich, 2009). The American International Group, for example consisted of numerous insurance as well as financial services companies. With the group active in numerous financial markets, the group was a significant counterparty to many systemically important banks, and thus was by itself systemically important (Econbrowser, 2009, p 1). The lack of transparency in its structure furthermore made it difficult for stakeholders to realize the risks facing the group (Econbrowser, 2009, p 1).
"If there's a single episode in this entire 18 months that has made me angrier, I can't think of one, than AIG.... AIG exploited a huge gap in the regulatory system.... There was no oversight of the Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets-- took huge losses." (Econbrowser, 2009, p 1)
The collapse of AIG in 2008 illustrates the risks that can arise when different parts of a company follow different businesses with the same capital base.
Conclusions and the Way Forward
There is no doubt that insurance and reinsurance companies, by way of their very role as distributors of risk, play extremely important roles in bringing about financial stability and economic growth by smoothing the consequences of economic shocks, facilitating equity substitution and empowering businesses and individuals in various other ways. As financial mediators and large ticket investors, their actions in the financial marketplace can also have very serious consequences upon market stability.
With regard to the current economic crisis, it is obvious that the sector has weathered the crisis well. There is also much evidence to suggest that these sectors have played stabilising roles that have helped the global economy in reducing the impact of financial shocks and withstanding them better. These companies have not sold in declining markets but have instead continued to provide a range of insurance and reinsurance services. Such services have in turn resulted in premium income flows that have to some extent been invested in financial markets and bolstered them during days of intense crisis.
Much concern has however occurred over the role of financial groups containing insurance businesses, especially after the debacle witnessed at AIG in 2008. Investigation into the working of these groups reveals the existence of significant scope for bringing about improvements in the existing supervision and regulation system of insurance groups, especially of financial groups that also have insurance activities (Schich, 2009). Inadequacies in group supervision have emerged as an important area of deficiency and concern in the functioning of these organisations. Regulatory experts feel that greater sharing of information along with coordination and collaboration between supervisors can help in improving quality of oversight. Such supervision should take account of various issues like internal relationships within groups, procedures for governance and management of risk, allocation of capital, and transfer of funds.
It is expected that improvement of supervision and greater transparency in sharing of information will help significantly in improving the effectiveness of these sectors in countering financial instability.
2043 Words, apart from bibliography
