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posted on 25 December 2015

Report Of The European Systemic Risk Board ESRB The Big Short

by Dirk Ehnts, Econoblog101

The Report on systemic risks in the EU insurance sector has been published last week (download).

Here is an excerpt:

Given this role in the economy and the financial sector, the ESRB Insurance Expert Group (IEG)1 has identified four main ways in which insurers can be the source of systemic risks or amplify these.

First, in line with literature to date, insurers may amplify shocks due to their involvement in so-called non-traditional and non-insurance activities. [..]

Second, procyclicality can arise. [..]

Third, life insurers in parts of Europe could create disruption by failing collectively under a scenario with prolonged low risk-free rates and suddenly falling asset prices (i.e. "the double hit"). [..]

Fourth, underpricing by an insurer, if left unnoticed in microprudential supervision, could lead to a lack of substitutes in certain classes of insurance vital to economic activity. [..]

I would propose a fifth entry:

Fifth, under-/mispricing by an insurer, if left unnoticed in microprudential supervision, could lead to a credit bubble in certain classes.

Remember American Insurance Group AIG)? They insured clients against credit-debt default of underlying mortgages and real estate loans, assuming that the housing market in the US would not fall apart at the same time because historically it didn't. Even though the bail-out according to Wikipedia led to a profit for the US government, the misallocation of capital did hurt the US economy. Instead of real estate something else could have been build, and the return in terms of welfare improvement would probably have been better.

Reading the report more thoroughly I find that the first point covers cases like AIG:

First, in line with literature to date, insurers may amplify shocks due to their involvement in so-called non-traditional and non-insurance activities. These activities imply liquidity and maturity transformation, leverage, complexity and interconnectedness and include variable annuities, certain types of guarantees and speculative derivative transactions. A prime example for such risks is AIG in the financial crisis. A rough estimate of the amount of non-traditional insurance products in the EU is at least EUR 125 billion. Due to insufficient reporting the number is probably understated; the quality of reporting will improve under Solvency II.

Nevertheless I find the description "insurers may amplify shocks due to their involvement in so-called non-traditional and non-insurance activities" a bit too nice. Insurers may cause shocks if they engage in practices that are not scientifically sound. This can lead to very high profits in the short-run but huge damage in the long-run. I am quite sure that ESRB is aware of that. Speaking of which: The Big Short is out now. Sadly, it does not tell you what really happened but instead blames stupid people for buying financial assets that they did not understand. Anyway, here is the trailer. I hope that people who see the movie afterwards want to know more about what happened. Naked Capitalism has a good blog post on that.

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