by Viraj Shah
Insurance sector is one of the key components of Eurozone. The sector employs over 1 million people directly. Eurozone holds more than 7.3 million euros in assets and growing bigger by the day. The scope of improvement in the insurance sector is also remarkable. In fact, they are driving individuals and companies to a path of global financial success. However, it becomes important to check the systemic risks involved in this sector and how they can be tackled.
Insurance vs. Banks
Before we talk about the risks of insurance sector, we must know how insurance is different from other financial products and services. The treatment for bank and insurance liabilities is different. While bank liabilities are highly liquid and often short term, the same does not apply to insurance. Here, liquidity is less and the lock-in period is higher which provides a fair long term outlook towards investment.
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Another major factor to consider here is that an insurance liability will be generated if and only when a certain event (which is usually not called for) happens. The holder of the insurance has little to no control over the event because of which the liability is not easily callable. However, if someone happens to misuse the policy in any way or goes against the terms, then he may have to face penalties as well. This makes insurance a safer sector.
Aggregate Risk Mismatch
The risk involved here could be of the mismatch of aggregate risks. All insurance companies are dependent on modern told for calculating the value of insured assets, the financial risks as well as the management of their own money. This exposes them to an aggregate mismatch risk which will be affecting the entire industry at once. These risks are not directly under the control of the sector which makes it virtually powerless. For example, a capital management tool gone wrong could impact more than one insurance company at once.
Insurance companies run on the concept of diversification of risk. Most insurance companies use modern technology to calculate risks in the financial markets. This helps in assessing risks better. In fact, technology allows the insurance companies to predict future risks more accurately as well. Historically too, bond yields have had little to no effect on the insurance sector, making it a little more risk averse in the European countries. Insurance companies are known to use derivatives to manage their risks better, especially when it comes to equity-related and interest rate risks.
One of the other ways to do so is to focus on risk adverse product designs. While insurance products are designed to maximize returns and minimize risks. However, insurance companies are used for investment avenues too. One way of managing risk will be having a limited exposure to equities and a broader exposure to various instruments. However, when risk cannot be totally mitigated, it is wise to transfer the incidence of risk to other entities like reinsurance companies.
In the past two decades, reinsurance companies, capital market insurance schemes, and technological advancements have changed the risk portfolio or an insurance company. After 2008, the biggest losses were registered in variable annuities in US market. However, since then, more steps have been taken to hedge these risks.
Insurance companies are encouraged to take more risks in good times. However, as far as the current economic scenario goes, the companies could be more willing to minimize risks. The 2008 financial crisis has taught many lessons to the sector and considering the sturdiness of indexes like SYU Stern Systemic Risk Rankings, it is likely that the insurance sector will continue doing good overall.
Risk mitigation is one of the key factors to keep systemic risk at bay. Also, not to forget that it is one of the key drivers for employment generation.