After the Fall, Regulators Ponder the Threat of Non-Insurance Activities to Insurance Groups

Since the near-collapse of financial services giants such as American International Group, ING and Fortis, insurance regulators around the world have been vexed by the question of how to supervise multinational insurers who have significant non-insurance operations.

In all three of these cases, it was a non-insurance component of the corporate structure that threatened to bring down the corporate structure, possibly putting insured clients in harm's way for risks they didn't sign up for. The problem is now being taken up by the International Association of Insurance Supervisors.

In a guidance paper on the "treatment of non-regulated entities in group-wide supervision," the IAIS said it is seeking to "provide guidance on possible elements of an international framework for group-wide supervision -- the designation of a group-wide supervisor to promote effective and coordinated group-wide supervision and the establishment of supervisory colleges to facilitate enhanced cooperation and information exchange between involved supervisors."

This is no small matter, as the ongoing debate within the European Union over the supervision of insurance groups under the Solvency II directive shows.

The IAIS had already taken several stabs at providing guidance on insurance group supervision. This latest effort extends its guidance to non-regulated entities, "whether nonoperating holding companies or non-regulated operating entities." While acknowledging non-insurance activities (such as banking and securities trading) often fall under the jurisdiction of other types of regulators, the IAIS pointed out insurance supervisors still need to be aware of the risks posed by such activities on insurance groups.

Since the beginning of the global financial crisis in mid-2007, insurance supervisors have become keenly aware of the growing complexity of risk associated with cross-border and cross-sector financial groups and the inherent gaps in regulatory coverage that follow. Such risks have already come under scrutiny by international entities such as the Financial Stability Forum (now the Financial Stability Board) and the G20.

The IAIS, as a member of the Financial Stability Board, said it hopes to "enhance the supervision of non-regulated entities within and/or connected with an insurance group and hence contributing to the minimization of regulatory gaps and arbitrage."

The association's guidance paper was built on surveys taken among its members worldwide, regarding their approaches to non-regulated entities within insurance groups.

Among the problems -- either real or potential -- identified with insurance groups that have non-regulated entities, the IAIS pointed out corporate governance becomes difficult, as managers may not recognize the risks posed by one member of the group to other members. Or various operating units within a group may have conflicts of interest or work at cross-purposes. A lack of transparency may also arise in complex corporate organizations.

Of course, insurance groups with non-regulated activities are exposed to financial contagion and reputational risks arising from problems in their non-insurance segments. Brand damage was demonstrated clearly by AIG's saga, along with other groups. As part of the process of splitting up its businesses, AIG renamed its nonlife insurance operations Chartis. Fortis, after shedding its banking activities, will rename itself "ageas."

In AIG's case, the IAIS noted the reputation of the group's highly rated insurance entities was used to boost its financial products trading business, which specialized in the trading of credit default swaps -- the activity that nearly brought the entire organization down.

AIG also had a securities lending program through which it lent securities to outside institutions in exchange for cash collateral to be used in investments in retail mortgage-backed securities and other debt obligations. Such securities rapidly lost value as Lehman Brothers and other institutions began to falter.

All of these complex activities fell outside the normal scope of insurance regulators to some extent, making their projected impact on the insurance entities difficult to assess, at least before the problems arose.

With the lessons learned from the financial crisis, the IAIS said insurance supervisors will need to build a comprehensive group-wide approach to regulation that would take into account all the risks posed by non-insurance activities within the group. This will require quite a bit of cooperation and information-sharing among regulators, and clear risk management and reporting requirements for the insurance groups.

Regulators will also need to be prepared to impose appropriate risk-mitigation techniques when problems arise, including "ring-fencing" of problematic non-insurance entities when needed.

All of this will require an extraordinary level of cooperation among insurance supervisors. Perhaps the European Union's effort to implement Solvency II by 2012 will serve as a laboratory for the possibilities -- and limits -- of such cooperation.