Box D: Financial stability of New Zealand insurers
Banks and insurers are two of the major institutions within the financial system, having the important functions of enabling economic agents to spread consumption and investment over time, but without being exposed to unexpected risks. However, each institution carries out its functions differently, and thus how the Reserve Bank supervises each sector, and the regulatory tools it applies, will need to reflect those differences. This box explains the rationale for supervising insurers, and highlights some of the differences with banks.
Why supervise insurers?
The purposes of the Insurance (Prudential Supervision) Act 2010 (IPSA) are to: promote the maintenance of a sound and efficient insurance sector, and promote public confidence in the insurance sector. These statements provide the objectives for the prudential supervision of insurers in New Zealand, but do not explain why these are desired outcomes. The main reasons for supervision of insurers include:
- The insurance sector is an important contributor to the economy, providing risk management for individuals and businesses, and thereby facilitating economic growth;
- Significant information asymmetries exist between insurers and policyholders – policyholders rely on insurers’ skill and expertise to assess the probability and cost of an event. Prudential supervision requires that insurers manage their businesses soundly and maintain minimum prudential standards.
- Insurance often involves policy holders entering into long term contractual commitments for life, health, or savings policies. These contracts may be difficult to change, with the existing provider or by switching to another insurance provider. Policy holders therefore need to have a very high degree of confidence that the chosen insurer will meet their obligations over many years and even decades into the future.
Are New Zealand insurers ‘systemically important’?
The Financial Stability Board considers systemic risk to be where there is risk of an impairment of all or parts of the financial system, with serious negative consequences for the real economy. Table D1 summarises, in the New Zealand context, the criteria for considering systemic financial risk of banks and insurers as set out by the Financial Stability Board and the International Association of Insurance Supervisors.1 These criteria are the size the sector in the economy, how inter-connected institutions are with other institutions, how easy it would be to substitute the services of an institution were it to fail, and how quickly a failure is transmitted to other institutions and the wider economy.
Table D1: Comparison between banks and insurers of systemic risk criteria
|Size||Very large relative to the economy
Liabilities of NZ registered banks are about 140% of gross domestic product (GDP). The four biggest banks represent a high proportion of the total; each has liabilities in excess of 25% of GDP.
|Small relative to the economy
Liabilities of private NZ licensed insurers are about 5% of GDP, and under 1% for any individual insurer.2 Liabilities are currently higher than usual due to Canterbury earthquake claims.
Failure of a bank could cause other (unrelated) banks to fail. This is due to interbank lending, payment system linkages, and potential loss of confidence issues.
Failure of an insurer has been less likely to cause other financial institutions to fail. Interinsurer balances are very limited except for reinsurance and related insurers. Banks’ exposures to insurers have not tended to be large compared to their overall loan portfolios. Reinsurance is usually placed with large global reinsurers.
The banking infrastructure is highly dependent on a small number of banks and payment systems.
|Reasonably good substitutability
There are a large number of licensed NZ insurers and relatively few niches that depend on a small number of insurers.
|Speed of loss transmission||Failure crystallises rapidly
Due to the fundamental liquidity mismatch in banking, and the reliance upon confidence in banks, bank failures can rapidly crystallise.
|Failure generally occurs slowly
Other than catastrophic events, insurer failures generally occur slowly. Normal business activity may continue while resolution processes are implemented.
Failure of a bank can cause significant losses in the wider economy. This is because of contagion effects and the economy’s reliance on credit and banking services.
Failure of an insurer is less likely to cause significant losses in the wider economy except in extreme circumstances, such as after a major natural catastrophe or severe pandemic.
An assessment of these criteria shows that New Zealand insurers are less likely to create a systemic risk in comparison with banks, but individual insurance company failure may still occur.
The Canterbury earthquakes of 2010/11 are a good example of the impact of insurance failure on financial stability. The cost of the earthquakes was substantial – they ranked in the top 10 worldwide disasters of all time for insured losses. And because the Canterbury region was not considered a traditional earthquake zone the effect on insurers was difficult to anticipate. Nonetheless, only one major insurer failed: AMI Insurance Ltd. The Government had sufficient time to assume the Canterbury earthquake claims liabilities of AMI through the establishment of a new government agency, Southern Response, and also assumed a substantial proportion of the overall Canterbury losses through the Earthquake Commission. Local insurers have been able to meet their significant claims liabilities through their arrangements with major global reinsurers, and from additional capital provided by foreign parents. Consequently the transmission of the Canterbury earthquake costs to other financial institutions was contained, although there were wider impacts for the economy from subsequent increases in the cost of property insurance.
The GFC is another example of a systemically important event where very few insurers globally became distressed. Nonetheless the failure of global insurance giant AIG was judged systemically important and it received US Government support. AIG became distressed due to the exposures in the US sub-prime and derivative markets. New Zealand insurers have less complex business activities, and the Reserve Banks prudential requirements constrain the nature of their investments.
A risk based approach to supervision
Differences in the risks facing insurers and banks mean that the Reserve Bank will approach insurance supervision differently to banking supervision. It will use a risk based approach focusing most attention on those activities and events that have the highest probability and potential cost of failure. It will use the same ‘three pillars’ described in section 6.4 of self-discipline, market discipline, and regulatory discipline.
1 Financial Stability Board, International Monetary Fund and Bank for International Settlements (2009) 'Guidance to Assess the Systemic Importance of Financial Institutions,Markets and Instruments: Initial Considerations'.
2 Three large insurers are excluded from the Reserve Bank’s supervision: ACC, EQC and Southern Response. All are well supported by the New Zealand Government and do not compete with private insurers.