December 12, 2012 6:24 pm

Insurers must learn lessons from AIG

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Business is still being done in the name of insurance that bears little resemblance to it
Ingram Pinn illustration

Bob Benmosche, the amiably loud-mouthed chief executive of AIG, took his victory tour to London this week. “We are free at last,” he rejoiced to his fellow bosses as the US Treasury sold the last of its AIG stake.

It isn’t that simple. AIG has recovered from its multibillion-dollar losses but it still casts a long shadow over the insurance industry. The second-largest US insurer has placed its peers under suspicion, encouraging regulators to treat them like banks – more tightly regulated, holding more capital.

This annoys the world’s biggest insurers. “If you put higher capital requirements on insurance, you will have less insurance and lower growth,” says John Fitzpatrick, secretary-general of the Geneva Association, their trade body. “Why would central bankers who have the pedal to the floor to create growth want to depress it?”

Regulators have ignored similar arguments from banks in the past few years and they should discount this appeal too. Most insurance companies are smaller, sounder and safer than most banks but business is still being done in the name of insurance that has little resemblance to it. It would be foolish to forget the lesson of AIG the moment the US gets its money back.

Mr Benmosche was speaking at Lloyd’s of London, whose syndicates got into such trouble in the 1990s that the entire market had to be restructured. AIG’s collapse in 2008 was more significant, not only because it required a bailout but because of what AIG did.

As well as insurance it wrote credit default swaps on corporate and bank debt and lent securities to investors – activities that became toxic in the 2008 crisis. It was the most promiscuous of large insurers but not the only one to stray from its core – Swiss Re suffered big losses on default swaps.

The dangers of financial gambling being mislabelled as insurance go back a long way. The UK parliament passed an act in 1774 to stop people taking out life insurance policies on others – a risqué form of gambling. The act banned the use of insurance policies “for gaming or wagering purposes”.

Thanks to the abolition of Glass-Steagall in 1999 (lobbied for by Sandy Weill of Travelers to allow the merger of his insurance company with Citigroup), a strict division between insurance and hedging no longer exists. An insurance holding company can own a securities or banking arm – indeed, AIG still guarantees US mortgages.

Since the financial crisis, banks have been forced to hold more capital – especially too-big-to-fail banks that could have to be bailed out in future. It is sensible for regulators also to be more stringent with insurance holding companies. Otherwise, trading activities that become too costly for banks will simply transfer there.

This is so obvious that it is hardly worth debating. Global regulators are trying to match capital charges for systemically important banks such as JPMorgan Chase and Barclays with charges for systemically-important insurers. They are due to identify the latter shortly.

The insurers, however, are fighting back. The Geneva Association says it is happy for its members to be more strictly supervised than before (AIG’s regulator was previously the ill-fated Office of Thrift Supervision and is now the US Federal Reserve) but they don’t need extra capital.

Insurance is a less threatening activity than banking for the financial system as a whole. Life and property insurers can miscalculate the risk of having to make payouts – as Lloyd’s catastrophe syndicates did in the 1990s – but they rarely face the equivalent of a run on the bank. Most policyholders can only make a claim when something happens – a hurricane strikes or a life policy finally matures.

Unlike banks, they also tend to become more financially stable the bigger they get since the risks run by individual policyholders are not correlated. A bank that makes many mortgage loans to homeowners in one area increases its exposure to a property crash; a life insurer that sells policies to the same people diversifies its risks.

Thus, an insurance group may genuinely be too big to fail – or too big to run a great risk of failure. “We have encouraged them to grow and to diversify to make them less dependent on reinsurance. We should not tell them the opposite now,” says one insurance regulator.

Nor are insurance companies especially big compared with banks. The Geneva Association estimates that the world’s biggest 28 insurance companies are, on average, a quarter of the size of the largest 28 banks. They have much smaller derivatives portfolios and are far less vulnerable to short-term funding being cut off.

But this only proves that regulators should not treat insurers exactly like banks. They aren’t doing so. The International Association of Insurance Supervisors has drafted new rules that attach relatively little importance to an insurer’s size and more to what it does.

It would be very hard under these rules for any pure life or property insurer, no matter how large, to count as systemically important. The insurers at risk of having to raise capital are those such as AIG, which pursue other activities under an insurance holding company.

Unlike most other insurers, which hold little capital centrally, AIG has a pool of cash that it can pass to any operations that get overstretched – when hurricane Sandy struck the US it handed $1bn to its US property insurance arm. It may now be required to raise more.

It is an irony that other insurance companies will have to structure themselves more like AIG as a result of the 2008 crisis but it is perfectly rational. Whatever it discourages, it won’t be insurance.

john.gapper@ft.com

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