Lack of Demand for Innovation Helps Insurers Avoid Systemic Risk: Report

May 21, 2010

The 2008 financial failure and system breakdown of American International Group Financial Products did not contribute to broader systemic effects within the insurance industry, according to a new financial services think tank report.

The report also suggests that whether insurance is regulated at the federal or state level may not matter when it comes to systemic risk, although giving insurers an option of where to be regulated could change the risk scenario.

Martin F. Grace, a professor of legal studies and risk management and insurance at Georgia State University who serves as a senior research fellow for Networks Financial Institute at Indiana State University, presented his findings earlier this month in Washington, D.C. to a group of industry leaders, regulators and lawmakers.

While some policy analysts have suggested that the presence of systemic risk among insurers necessitates changing the governmental level at which all insurers are regulated, Grace’s policy brief suggests otherwise.

By examining the month-long turmoil that began in September 2008, Grace concluded that the insurance industry did not avoid systemic risk — which includes system breakdown, causality of loss and uncertainty in evaluating the relative strengths of insurance companies — as a result of state-based insurance regulation.

Rather “that success is more likely attributable to the fact that insurers differ from banks. A demand for financial innovation by banks which help them to fix their asset-liability maturity mismatch though securitization did not exist in insurance.”

Further, Grace’s research concludes “the governmental level at which insurance is regulated is immaterial as long as similar moral hazard risk is present in both regulatory systems. However, there is a risk that this would change if an Optional Federal Charter law is enacted.”

Terrie Troxel, acting director of Networks Financial Institute in the Donald W. Scott College of Business at Indiana State, said Grace’s findings have significant ramifications for the financial services industry.

“The structure, operations and size of AIG are unique,” Troxel said. “Traditional insurance products AIG and other insurers offer do not threaten contagious financial failures.”

Networks Financial Institute is in the Scott College of Business at Indiana State University.

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