On the Financial Regulation of Insurance Companies

The insurance sector, notably the monoline insurers and A.I.G., played a crucial role during the boom of 2004-2007 by guaranteeing a variety of credit risks using both insurance policies and significantly substitutable credit derivatives. These guarantees yielded huge losses and liquidity requirements for these insurers when the guaranteed assets declined in value. The large losses recorded by and diminished solvency or even failure of insurers contributed significantly to the severity of the financial crisis and the need for governmental support. In fact, A.I.G. remains under government receivership, and several other large life insurers have received significant capital infusions from the government. Given these facts, it is surprising that regulatory reform plans have not focused to any significant extent on the insurance sector. This paper presents a discussion of the key issues facing the financial regulation of insurance companies in the post-crisis era. While the moral hazard created in the financial sector by provision of financial guarantee insurance is difficult to overstate, we focus on the issues concerning insurers' excessive provision of insurance, under-capitalization, and related systemic risks. We argue that these systemic risks stem from a too-interconnected-to-fail problem, manifested most perversely in the case of A.I.G. We provide a way to measure the systemic risk contributions of insurers based on market data and calculate this measure (called Marginal Expected Shortfall or MES) for insurers in the United States during the period 2004-2007. We show that several insurers ranked highly on this measure compared to systemically risky banks over this period. We examine possible reasons for the emergence of insurers' too-interconnected-to-fail problem. Under the current regulatory structure, when an insurer operating in a state defaults, state guarantee funds insure losses to the policyholders by charging premiums to other insurers operating in the state. Because these premiums are imposed after the fact and are not based on insurers' risks, they provide no incentives for insurers to avoid systemic risks. Moreover, the absence of a federal regulator that can assess the systemic risk of insurers operating across states, charge them upfront premiums for their systemic risk contributions, and suitably manage their resolution in case of default is a significant problem. We propose therefore a federal insurance regulator and discuss its appropriate powers and relationship to federal banking regulator. We compare existing Treasury Department proposals to our recommendations and identify several areas for improvement. 1. A national insurance regulator for financial institutions with a …