When I consider the FSOC’s SIFI Designation for non-banks I’m reminded of two things: 1) The Difference Between Banks & Insurance Companies
2) I’m reminded of the joke:
“Do you know the difference between an elephant and a dozen eggs?”
“No, what’s the difference”
“Well if you don’t know, remind me never to send you to the store for a dozen eggs”
“Do you know the differences between Banks and insurance companies”?
“No, what’s the difference”?
“Well if you don’t know….” You get the point.
SIFI Guidelines for non-Bank Companies
In the aftermath of the credit crisis and passage of The Dodd Frank Act, the (FSOC) Financial Stability Oversight Council mandated which financial institutions were Systemically Important Financial Institutions (SIFI).
During the height of the crisis AIG, Radian & XL Insurance were in the headlines. So they became synonymous in the public’s mind of what an insurance company does. But compared to MetLife or Allstate, these companies couldn’t be more different than a Chanel Suit and a Track Suit. But the FSOC decided that they needed to explain their process for designating an insurance company a SIFI. You can read their process here: SIFI Designation for non-bank companies.
This blog takes a look at the FSOC’s SIFI Designation Process and explains the difference between banks and insurance companies. You may have to look elsewhere for the difference between a dozen eggs and an elephant.
The SIFI points of evaluation are:
1) Size (measure is not further evaluated in this blog)
2) Institutional Interconnectivity
5) Liquidity Risk & Maturity Mismatch
6) Existing Regulatory Scrutiny
Banks fund themselves in the interbank market. They borrow and lend funds from/to other banks creating direct interconnectivity between banking institutions. This interconnectivity can be taken once step further by pointing out that the Central Bank shows that banks operate within a system.
But Insurance companies are stand alone institutions. They receive premium from clients in return for payment upon death in the case of life insurance. In the intervening time, the insurance company invests the clients premiums. While one might be tempted to compare the interbank market to the insurance-reinsurance relationship, the small size of this activity renders it unimportant and not truly systemic.
Transformation of Maturity
Banks make long term loans and tend to fund them short term. On the funding side insurers as opposed to banks are funded long term (via premiums). Insurers don’t transform maturity. They run liability driven investment policies and match their asset profiles with their liabilities.
Deposits are the largest item on a banks’ balance sheet. And deposits can be withdrawn at any time. Bank are by their nature liquidity seeking businesses.
Insurers ( annuity life, p&c & health) policies are not called at will. Only non-annuity life policies are theoretically callable. However, the penalties for early withdrawal and possible elimination of tax benefits may make early withdrawal too costly.
Credit, Money & Payment function
Bank are an organization of settlement systems. Bank create credit, deal wth the payment function and the liabilities are money.
Insurer liabilities do not constitute money, rather they are an illiquid future financial claim. Insurers do not provide essential market utilities. Coupled with the fact that they’re less integrated to the financial markets in that they are not an organizationally part of settlement of payment systems.
Similarities between Banks & Insurance Companies
Certainly there are similarities between them with both being financial intermediaries & their respective roles as investors. There are two other areas related to systemic risk worth mentioning: leverage & capital. While common to banks and insurers, each is used in very different ways.
Leverage in banking can be measured by dividing equity over debt. While this is valid for banks, insurance companies leverage is best measured as debt divided by assets. Rating agencies measure insurance companies leverage in the same way as well as debt over pre-tax earnings.
Applying a capital surcharge to banks to reign in the creation of leverage via asset acquisition and credit growth is logical and makes sense. Insurers can reduce the debt leverage but they can’t reduce their insurance assets because this would imply cancelling insurance contracts with existing policyholders, which is generally not allowed. So applying a capital surcharge to insurance companies won’t accomplish the brake on leverage it accomplishes with a bank.
Banks and insurers funding needs are quite different. In the event of a crisis a bank borrows money and uses that liquidity to payback the depositors while Insurers borrow money and use that liquidity to payoff the last policyholder.
Existing Regulatory Scrutiny
U.S. Insurance Companies are regulated on the federal level by the National Association of Insurance Commissioners (NAIC) which provides accreditation of national solvency standards, oversees centralized processes for company licensing amongst other things. U.S. insurance companies are regulated by the state in which they are registered to do business. Read more about U.S. Insurance Regulators here.
Ciriticisms of SIFI designation Process of NFC’s
- FSOC does not provide the information which led to SIFI designation
- The SIFI Designation process itself is not transparent
- A lack of fundamental rigor in theSIFI evaluation process
- FSOC does not give the NFC’s the time or an opportunity to more comprehensive information to assist the process
- The conseuqnece of SIFI designation and enhanced regulation are still uncertain
- FSOC has not shared how the implications of SIFI designation will intermingle with the international processes.
Capital Surcharges aren’t the best solution to deal with systemic risk with regard to insurance companies. Size limits, changes in certain contracts and maybe separate guidelines for complex contracts offers a more tempered approach and one which is more fitting given the insurance business model.
Greater Regulatory Supervision will increase the administrative costs at the life insurers as well. Add to this the unknown implications of SIFI designation and overseas regulators makes this issue all the more of a concern.
Food for thought. Have an opinion – Please put it in the comment section below