There is a splendid character in a 1934 short story by American author Damon Runyon who was called Joe The Joker. The gangster’s speciality was giving people what he called a hot foot. To quote Runyon, it involves sneaking up behind his victim and inserting a paper match between the sole and the upper of his shoe and then lighting it. “By and by the guy will feel a terrible pain in his foot and will start stomping around and hollering and carrying on generally.”
Well it looks like the Organisation for Economic Co-operation and Development (OECD) may have given the insurance industry the equivalent of a hot foot with a slow burning, potentially painful, report* that it just slipped out without anyone noticing.
The report ostensibly presents statistics which clarify the nature of the impact of the crisis on the insurance industry in OECD countries, before reviewing governmental and supervisory responses to the crisis.
Reading the report, insurers and reinsurers won’t feel a thing for a bit. They may have felt a little discomfort to start with when the OECD mentions how “the insurance sector played an important supporting role in the financial crisis by virtue of the role played by financial guarantee insurance in wrapping, and elevating the credit standing of, complex structured products and thus making these products more attractive to investors and globally ubiquitous”.
But that is soon shrugged off in the course of the first 40 or so pages as the OECD discusses what happened in the crisis, homes in on trade credit insurance and mentions insurers’ role as a bystander in the crisis.
Insurers will start to feel a burning sensation at around page 40. The hot end comes where the OECD’s authors identify policy and regulatory issues and propose conclusions that they believe will promote financial stability and enhance the protection of policyholders.
Some of it, when its contents register, is guaranteed to have the insurance industry stomping around and hollering in a rage.
For example, after acknowledging that the insurance model is quite different to that of banks and that insurers “fared the crisis relatively well considering the extreme systemic
stress events”, it raises issues it says are common across the financial sector. It suggests:
* Insurers, along with other financial institutions, should have a comprehensive, integrated risk management system and effective communication and reporting systems to properly identify, assess, control (as appropriate), and monitor risks;
* The crisis has demonstrated the need for board members to have sufficient knowledge, expertise, and time to oversee and direct a financial institution properly, and effectively challenge management. This issue is particularly crucial in the insurance sector given the complexity of insurance products and markets;
* Insurers should pay due attention to excessive risk-taking behaviour, as well as potentially misaligned incentives throughout the organisational structure, including at the level of sales agents;
* Insurers should not rely solely on the ratings provided by rating agencies in their risk management and investment decisions but should perform their own due diligence.
It gets better.
It says that the provision of insurance in a transaction may introduce moral hazard where none previously existed. That is, the policyholder, in the knowledge that he or she will be compensated in the event that the insured event occurs, may be less proactive in managing risks, unless the insurer can impose measures to limit such moral hazard. The OECD thus argues that the presence of insurance protection can lure third parties in transactions into a false sense of security paradoxically leading to a build-up of risk in the chain.
It concludes that consideration may need to be given to whether supervisory mandates need to be broadened “to ensure that proper consideration is given, on an on-going basis, to system-wide and macro-prudential issues (and possibly also cross-border matters) and to matters that go beyond retail policyholder protection.
“For instance, the interaction of sophisticated players in financial and insurance markets may create market failures, such as systemic instabilities, as demonstrated by the financial guarantee market.”
The OECD concludes that insurance regulators should make the supervisory system more robust…
There’s more: closer attention should be paid by policymakers, regulators, and supervisory authorities to the linkages between insurance markets and macroeconomic conditions. “For instance, it has been argued that, in industries like trade credit insurance, ample liquidity and benign macroeconomic conditions led to weakened underwriting standards, and by consequence to the build-up of risks, which inevitably had to be sharply reversed in the context of adverse economic circumstances, harming policyholders and further amplifying macroeconomic shocks…“
Oh, there’s plenty more where that came from. In fact, by the end of the report some insurance people will be left thinking they started the crisis and then poured petrol on it.
Others, like the hapless victims of Runyon’s Joe The Joker, will simply be left hopping mad.
By Garry Booth, contributing editor
*The Impact of the Financial Crisis on the Insurance Sector and Policy Responses