Risk Management and the Global Banking Crisis: Lessons for Insurance Solvency Regulation

The Geneva Papers, 2011, 36, (330 – 347) r 2011 The International Association for the Study of Insurance Economics 1018-5895/11 www.genevaassociation.org Risk Management and the Global Banking Crisis: Lessons for Insurance Solvency Regulation Simon Ashby School of Management, Plymouth Business School, Drakes Circus, Plymouth PL4 8AA, U.K. E-mail: This paper investigates the causes of the banking crisis and the resulting lessons that need to be learned for insurance regulation. The paper argues that the banking crisis was predominantly caused by weaknesses in the management and regulation of banks, weaknesses that lead to problems such as flawed compensation schemes, poor risk management communication and an over-reliance on mathematical risk models. On the basis of these findings, doubts are expressed about the direction of certain insurance regulatory reforms—such as the focus on capital requirements and quantitative risk assessment (the so-called “Pillar I” of most reforms). It is also recommended that a more balanced approach to insurance regulation should be implemented, which places much greater emphasis on enhancing risk management guidance and supervisory tools (Pillar II) and improving disclosure rules (Pillar III). The Geneva Papers (2011) 36, 330 – 347. doi:10.1057/gpp.2011.10 Keywords: insurance regulation; solvency regimes; financial crisis; risk management Introduction The regulation of insurance companies is at a global crossroads. Many countries are in the process of reforming their regimes, including the whole of the European Union with the Solvency II project and the United States with the National Association of Insurance Commissioners’ (NAIC) “Solvency Modernization Initiative”1 and even more significantly for the U.S. the July 2010 Financial Reform Act and the creation of a new federal insurance agency.2 In addition the G-20, supported by “The Joint Forum” of international financial services supervisors, has called for the closer harmonisation of solvency regimes across the financial services sector,3 while the International Association of Insurance Supervisors (IAIS) is working towards a common framework for the supervision of internationally active insurance groups 1 NAIC (2010). The July 2010 U.S. Financial Reform Act established the Federal Insurance Office (FIO) within the Department of the Treasury. Its role is to gather information about the U.S. insurance industry, including access to affordable insurance products by underserved communities, and monitor the insurance industry for systemic risk purposes. The FIO will also coordinate international insurance matters. For an analysis of the new U.S. regulatory system and its drivers see Cooper (2009). 3 Joint Forum (2010). 2 Simon Ashby Risk Management and the Global Banking Crisis 331 and has issued various “principles”, “standards” and “guidance” on the design/use of solvency regulations.4 While some of these reforms were well established before the global banking crisis (e.g. the Solvency II project), the crisis has had a significant effect on their content and direction. Understandably insurance regulators are keen to learn from the banking crisis, analysing its causes and consequences to help improve the effectiveness of their own solvency regimes. This paper adds to the current literature on the banking crisis and the associated direction of insurer solvency regulation in the following ways. First, it draws on an analysis of the root causes of the recent banking crisis to examine the micro (human/ cultural) level factors that can influence the risk management decisions of financial institutions. Second it shows how poorly implemented regulatory reforms can adversely affect the risk management activities of financial institutions. To support the above analysis, the paper uses evidence from interviews with 20 senior risk management professionals from a range of U.K. licensed financial institutions, including 11 from institutions operating within the insurance industry. These interviews were conducted in the immediate aftermath of the initial phase of the crisis (July/August 2009) and so provide an early, first-hand, account of its causes. The paper makes recommendations on how the prudential regulation and supervision of insurers could be improved. In so doing, it supports and develops the work of Doff, Eling et al. and Eling and Schmeiser,5 arguing that a more holistic approach is required that balances technical capital rules with a greater emphasis on risk management standards/practices and market disclosure. It is also recommended that supervisors should place more emphasis on the assessment of qualitative factors such as management expertise, attitudes and judgement or the nature of an insurer’s risk culture. The next section begins with an explanation of the methods used to collect and analyse the testimonies that were obtained from the selected risk management professionals. The section after that then uses these testimonies to explore the root causes of the banking crisis and their implications for insurer solvency regulation, while the subsequent section provides recommendations in the light of this analysis. The last section ends with a conclusion and some suggestions for future research. Methodology Approach: Semi-structured interviews To explore the reasons behind the banking crisis a series of semi-structured interviews were conducted. The interviews focused on the opinions of the respondent in relation to: the cause(s) of the current financial crisis; the role of risk management and its 4 For a discussion of the IAIS’s core principles on capital adequacy and solvency see IAIS (2002). Note that these principles are being updated, with the adoption and publication of a set of new principles expected in 2011. 5 Doff (2008); Eling et al. (2006); Eling and Schmeiser (2010). The Geneva Papers on Risk and Insurance—Issues and Practice 332 implementation; how organisational factors (i.e.—culture and governance) may have contributed to events; and participants’ comments on the future in relation to sector regulation and the understanding and management of risk. Appendix A lists all the questions that were asked. Semi-structured interviews were chosen because they provide the interviewer with an opportunity to explore a range of complex and potentially sensitive issues. They allow conversation to flow more freely than structured interviews, affording the interviewee an opportunity to express their personal opinions, concerns and feelings, while still ensuring that there is a sufficient degree of structure to allow comparisons between interviewees. Grounded theory approaches, such as the analysis of semistructured interviews, are particularly well suited to this type of organisational analysis because of their ability to capture the complexity of real-world contexts and to link theory with practice.6 Scope of analysis: The interviewees In total 20 interviews were conduc (...truncated)