Report Warns Against Applying Systemic Risk Regulation to Insurers

September 22, 2009

Blame for the financial crisis and the near collapse of American International Group should reflect “the substantial evidence of fundamental failures in U.S. and foreign regulation of commercial banking, thrift lending, and investment banking,” according to a new report that analyzes the role of AIG and the insurance sector in the financial crisis of 2008-2009.

The report notes that AIG’s problems were heavily influenced by its credit default swap portfolio, which was assembled by a non-insurance AIG subsidiary that was not subject to insurance regulation.

The report, “The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation,” was written by Scott Harrington, professor of insurance and risk management at the University of Pennsylvania’s Wharton School, and published by the National Association of Mutual Insurance Companies (NAMIC).

Harrington calls AIG an “anomaly” in an insurance sector that “was largely on the periphery of the financial crisis.” The financial crisis and the government’s rescue of AIG “do not strengthen arguments for either optional or mandatory federal regulation of insurance,” Harrington writes.

Nor, he adds, do these events justify creation of a systemic risk regulator with authority over insurers and non-bank institutions that are designated as “systemically significant.”

Compared to banking, systemic risk is relatively low in insurance markets, especially for property/casualty insurance, according to Harrington, because insurers hold greater amounts of capital in relation to their liabilities. This reduces their vulnerability to shocks in the economy.

But the creation of a systemic risk regulator, which is under consideration in Washington, “would very likely undermine market discipline and protect even more institutions, investors, and consumers from the downside of risky behavior.”

The report questions whether the AIG crisis would have been averted if federal insurance regulation been in place before the onset of the financial crisis. Noting that federal regulators failed to anticipate or prevent the implosion of Citibank, Bank of America, and other bank and investment bank holding companies, Harrington concludes that “it’s just as likely or more likely that federal regulation of large insurers would have further increased risk.”

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