Lecturer: Role of Insurance in Global Financial StabilityIntroductionThe global financial crisis which began in 2007 greatly accelerated and affected many countries and companies. The crisis posed unique challenges for financial market regulators, especially insurance companies about how financial risks should be mitigated and what financial policies should be put in place to stabilize financial systems. In the United States, the severity of the events which transpired during and after the crisis has been a shock to the country’s political and financial system. The crisis brought to the forefront the issue of what insurance companies should do to stabilize impaired financial institutions (Eling & Schmeiser, 2010).
While the financial crisis may have been primarily a banking crisis, but the solvency of the global insurance sector and the entire financial sector in general was severely threatened. In particular, insurance companies were affected in several diverse ways, primarily because of their heavy investments in portfolios. As a result, different views have been expressed regarding the role of the insurance sector in stabilizing the global financial system. One of these views is that the insurance sector can stabilize the financial systems by absorbing systematic risks that pose major threats to banking institutions. While the insurance sector was not the origin of the financial crisis and did not repackage any of the subprime mortgages that led to the crisis, the insurers were major financiers of the mortgage-based financial instruments.
As such, the insurance sector was at a position to rekindle market volatility through its capacity as a long-term investor. In this way, the insurance sector can act as a stabilizing sector in the financial market during moments of stress.
This research paper reviews vulnerabilities in the global financial system and what role the insurance sector can play to suppress the impact of these vulnerabilities. Role of Insurance Companies as Shock Absorbers during Financial CrisisTraditionally, the primary role of the insurance sector is to give indemnity to individual and corporate policyholders. The indemnity is usually given to claims resulting from adverse events, but the insurers can also give provide a stable means of long-term savings for the policyholders. To guarantee indemnity and savings, insurance companies have to rely on diversification of risks.
Risk diversification is effected by pooling of different policyholders risks and by diversifying across different kinds of risks (Eling & Schmeiser, 2010). Nevertheless, some risks remain after diversification and these require other mitigation techniques such as hedging, reinsurance and use of insurance linked securities. In general, insurance companies incorporate several risk management practices such as asset-liability management practices to offset asset-liability mismatches. Moreover, a variety of supervisory practices and regulatory frameworks are engaged to maintain high solvency levels in the insurance industry. In some countries, the actuarial profession is engaged by insurance companies to manage risks.
Some countries have even enacted statutory requirements for insurance companies to obtain appropriate actuarial services in their business operations. Despite these sophisticated risk management practices, insurance companies occasionally become distressed financially and in the modern financial markets where competition is very high, financial distresses and insolvency can occur quite often. Fortunately, the financial distresses of the insurance companies can last for a considerably long time (Eling & Schmeiser, 2010). This is because the insurer’s assets do not usually get liquidated until benefits under policies are paid.
As such, insurance regulators have time to intervene to check the potential losses arising from insolvency, although this might not always be the case since different distresses are caused by different factors and impact differently.