A flaw in the formulation of higher capital charges for global systemically important insurers (G-Siis) could incentivise firms to increase rather than reduce systemic activity, according to Lutz Wilhelmy, head of governmental affairs at Swiss Re.
By linking the calibration of the higher loss absorbency (HLA) capital requirement to the riskiness of G-Siis compared with each other, the measure makes it rational for firms collectively to increase non-traditional, non-insurance activity, he says. "Given the HLA will be calibrated to an average, it may become economically rational to do as much systemic activity as possible because this activity usually comes with a better return."
The International Association of Insurance Supervisors (IAIS), which is leading the development of international capital standards for insurers, released a consultation paper in July saying the HLA will be based on the basic capital requirement (BCR) – a lower capital charge for G-Siis that took effect this year – with an initial 33% uplift plus a further surcharge. The additional amount will not exceed 20% for the G-Siis as a group, the association says.
This element of the capital requirement is therefore calculated for firms in aggregate before being applied individually, to make sure it does not exceed 20% for the group as a whole.
If the G-Siis engaged in equal levels of systemic activities, Wilhelmy says, the calibration of charges would lead to all nine receiving a surcharge of 20%. But if they all increased systemic activity in parallel, the surcharge would stay at the same level. "It is completely relative," he says.
Given the current methodology, it is a dangerous possibility
Wilhelmy, whose own firm was understood to be in line for designation as systemically important until the process for designating reinsurers was delayed, does not suggest firms will explicitly discuss increasing systemic activity. But an increase could happen if all the G-Siis "march in the same direction and increase systemic activities", he says.
"Given the current methodology, it is a dangerous possibility," he adds.
The IAIS has also suggested firms be separated into different ‘buckets', based on their systemic activity, a classification that will also affect the capital requirements they face. Again, the calculation is based on firms' systemic risk relative to each other rather than their individual systemic profile, says Wilhelmy.
Janine Hawes, director at KPMG in London, says: "While the proposed bucketing approach uses G-Sii assessment scores [which are used to designate firms], these scores have not been made public and are, in effect, relative measures. It is unclear how this will actively incentivise groups to de-risk, as de-risking may not affect their relative position, meaning little or no reduction in the amount of their HLA."
Wilhelmy says: "I tried to figure out the rational reasoning behind the 20% figure. The IAIS argument seems to say ‘in the absence of a better argument, we are going to look at what they are doing in banking and apply it'. That avoids the real debate on what systemic activities actually exist in insurance."
"We are very concerned that size will play a bigger role in capital charges than systemic activity. While this might make sense for banks, size is actually a good thing for an insurer or reinsurer because it is a prerequisite for better diversification of risks," he says.
The week on Risk.net, March 10-16 2018Receive this by email