Evolving Approaches to Systemic Risk Regulation in Insurance

Abstract

After the 2008 financial crisis, policymakers developed two different approaches to systemic risk arising from insurance conglomerates and other nonbank financial firms. The first, dubbed an entity-based approach, empowers a public entity like the Financial Stability Board or Financial Stability Oversight Council to designate individual nonbank systemically important financial institutions for enhanced regulation and supervision. The second, known as an activities-based approach, seeks to regulate financial activities that can produce systemic risk. Updating the authors' previous work on nonbank systemic risk, this book chapter evaluates how policymakers' approaches to systemic risk regulation in insurance have evolved since the crisis. It tracks how international standard-setting organizations and U.S. regulators initially relied on the entity-based approach, using discretionary methodologies for identifying specific nonbank firms, including insurers, that were systemically significant. It then shows how, in response to backlash, international and U.S. policymakers abruptly ceased entity-based designations and purported to shift their focus to an activities-based approach to nonbank systemic risk.

This chapter contends, however, that rumors of the demise of entity-based systemic risk regulation are premature. Instead, prevailing regulatory strategies for nonbank systemic risk retain strong elements of an entity-based approach, particularly in the insurance sector. The key change is that insurers subject to enhanced systemic risk regulation are no longer chosen using complex, multi-factor tests that require regulators to exercise significant discretion. Instead, regulators rely on more formulaic rules to identify insurers that could pose systemic risks and, at least in theory, regulate them accordingly. These developments demonstrate that an entity-based approach is an indispensable component of effective nonbank systemic risk regulation. Policymakers’ continued emphasis on entity-based strategies is sensible because effective systemic risk oversight requires consolidated regulation that focuses on the cumulative impact of a financial conglomerate’s activities. Activities-based approaches, meanwhile, are often difficult to implement outside of an entity-oriented regime. Thus, the much-heralded shift to activities-based systemic risk regulation in the insurance sector may prove in the long run to be mostly rhetorical. Entity-based systemic risk regulation in the insurance sector is here to stay. The principal remaining question is whether it will be designed and implemented effectively.

Keywords: Insurance, Systemic Risk, Financial Stability, Financial Stability Board, Financial Stability Oversight Council, Nonbank Financial Companies, Entity-Based Regulation, Activities-Based Regulation