In most financial systems (with Bermuda being an interesting exception), banks dominate the financial landscape in terms of their absolute and relative scale and economic importance. We witnessed the potential consequences of that during the Great Financial Crisis, when highly-leveraged, under-capitalized banks had to be bailed-out by public money (i.e., the taxpayers) on a huge scale- something whose effects still linger even now.
Of course, over the past 10 years, regulation and re-capitalization have significantly strengthened many banks’ financial position, even if sustainable business models still elude quite a number of mainly European banks. However, the fact remains that, in the fractional reserve banking system which is still the dominant model, any bank needs to maintain a highly-leveraged business structure in order to generate the returns which shareholders expect and is inherently subject to the risk of a “run” if confidence falls.
There are now increasing signs that regulation fatigue, political amnesia and pandering to vested interests are leading to pro-cyclical, rather than the necessary anti-cyclical behaviour amongst regulators in the world’s largest financial market- the US- at a time when both the credit and businesses cycles are potentially approaching a reversal, even if not another “crash”. In fact, changes in regulation can fuel a boom- consider what happened after the repeal of the Glass-Steagall act.
As we are seeing now, risk also tends to migrate away from the regulated to the unregulated components of the financial system- as the rise of so-called “shadow banking” and “FinTech” demonstrates, further obscuring sources of potential trouble. If regulators do not pay attention and “follow the money”, they are, in essence, condoning a rise in systemic risk.
And while the phrase “This Time is Different” is not yet being uttered as a general mantra, the longer time passes without even a recession, the greater the risk that people, including “experts”, will start to believe that the beast of the Business Cycle has finally been tamed, with excuses being made to justify that belief, even in the face of contra-indicators. One can already observe this is the debate going about the “meaning” of the recent US yield curve inversion.
Compare that scenario with that of the (re)insurance industry. While (re)insurers may carry some leverage (usually at the holding company level, not at regulated subsidiaries), the cost of, or risk of withdrawal of funding is rarely an issue. Similarly, they are not subject to liquidity puts, nor deposit outflows. What happened to AIG in 2008 is the exception that proves the rule, yet its core insurance businesses were able to continue to meet their obligations without stress, in an environment that was potentially chaotic.
In reality, in the absence of fraud or serious mismanagement of pricing, aggregations and reserves, diversified P&C (re)insurers very rarely fail. This is not a reason to be complacent, nor to assert that such a thing cannot happen. However, the evidence built over many decades and business cycles is clear. Companies’ business models may become obsolete, or they may have reserving issues, but even then the consequence is usually an orderly run-off, rather than precipitate failure.
The key distinction between banking and (re)insurance is that duration mismatch is a necessary element of any banking system but not present in the re/insurance industry. While both industries have to pay close attention to their ability to cover realized losses and ensure adequate levels of risk capital (equity or the equivalent), only banks have to deal with the embedded liquidity risk that comes from that duration mismatch.
At Awbury, even though the quality of our partner (re)insurers is very high, and they are all large, diversified P&C businesses, we constantly monitor their financial performance and condition, because we believe that one should never assume that “received wisdom” cannot change; and we would be doing our clients a disservice if we did not maintain vigilance.
The Awbury Team