Introduction
Insurance companies’ balance sheets are fundamentally different from the classic bank model. While banks record investments such as loans or bonds on the asset side of their balance sheets, insurance companies list the assets they have insured. Correspondingly, they record a provision on the liability side. This essay will explore the differences between bank and insurance company balance sheets, the specific risks faced by insurance companies like AIG, and the implications of regulatory frameworks such as Solvency II.
Bank Balance Sheets
To understand the difference, let’s look at Bank of America’s latest consolidated balance sheet. Banks use deposits to lend money, but these deposits are not the bank’s property and should not be at risk. If there is a credit default, market risk, or operational risk, the so-called “capital tier 1 and 2” should cover that risk. According to Basel II, the capital requirement is 8%. In this example, shareholders’ equity is $177 billion, which should represent more than 8% of the assets at risk.
Insurance Company Balance Sheets
In contrast, insurance companies operate differently. Examining AIG’s balance sheet reveals that to insure an asset, an insurance company does not need to have the asset value in deposit. Instead, they calculate the risk and establish a premium. This allows insurance companies to leverage highly because the investment for insuring is close to zero. For example, after receiving a premium, an insurance company invests it to generate investment income. In AIG’s case, over 60% of their fixed assets are invested in bonds. These bonds, held by other investors, are also insured by AIG.
This double exposure presents significant risks. If the bond issuer defaults, AIG faces two problems: they must pay the policyholders and they lose the asset. The question then arises: do they have sufficient reserves to handle such a scenario? The analysis of AIG’s liabilities shows that their shareholders’ equity of almost $100 billion would not cover such a situation. This topic merits further discussion.
Comparison with Bank Deposits
The policyholder contract deposits represent the deposits that can be used in case of risk. However, compared to Bank of America’s deposits, the percentage of deposits in AIG’s liabilities is much lower. To conclude our comparison, insurance companies are less regulated, and a high-loss scenario could be fatal.
The main reason is that to finance fixed assets, you should have fixed liabilities, which banks achieve by using deposits to finance loans. When examining AIG’s balance sheet, their fixed liabilities are insufficient to finance their fixed assets. Additionally, AIG’s fixed liabilities should also cover potential risks.
Solvency II and Its Impact on Insurance Companies
Solvency II is a regulatory framework designed to enhance the stability of insurance companies. It introduces stricter capital requirements to ensure that insurance companies hold sufficient capital to cover their risks. The main features of Solvency II include:
- Capital Quality: The capital quality of Solvency II must be respected. Low-quality capital (Tier 3) should not exceed one-third of the total capital.
- Solvency Capital Requirement (SCR): This corresponds to the economic capital a (re)insurance undertaking needs to hold to limit the probability of ruin to 0.5%, i.e., ruin would occur once every 200 years. Each insurance company must have its own capital requirement based on the risks they are taking.
AIG Balance Sheet Analysis and the CDS Market
Prior to the financial crisis, AIG’s balance sheet was exposed to significant risks due to the rapid growth of the Credit Default Swaps (CDS) market. Typically, an insurance company manages risk by calculating the likelihood of an event and setting a premium that covers the risk while allowing the company to profit. However, the CDS market operates differently.
In a normal insurance scenario, risks are independent; for example, if your neighbor’s house burns down, it does not affect the likelihood of your house burning down. In the CDS market, risks are interconnected and exponential. A single large credit default can trigger a cascade of defaults, overwhelming the insurer’s capacity to pay out claims. This exponential risk is what led AIG to seek assistance from the US government during the financial crisis. They could not cover the vast number of defaults, highlighting the inadequacy of traditional premium strategies in this market.
Regulating the CDS Market under Solvency II
Regulating the CDS market poses unique challenges. The standard Solvency II framework does not account for exponential risk. Therefore, additional measures are necessary to address these risks. Potential regulatory approaches could include:
- Enhanced Capital Requirements: Increasing capital buffers specifically for CDS exposures.
- Stress Testing: Regularly conducting stress tests to evaluate the impact of extreme market conditions on the insurer’s balance sheet.
- Risk Diversification: Encouraging insurers to diversify their investment portfolios to reduce exposure to correlated risks.
- Transparency and Reporting: Implementing rigorous reporting standards to ensure that all CDS exposures are transparently disclosed and monitored.
Conclusion
In summary, the balance sheets of insurance companies differ significantly from those of banks, primarily due to the nature of their liabilities and assets. Insurance companies face unique risks, particularly in markets like CDS, which require careful management and regulation. The introduction of Solvency II aims to strengthen the stability of insurance companies by imposing stricter capital requirements and risk management standards. However, addressing the exponential risks in the CDS market requires additional regulatory measures. Understanding these differences and regulatory impacts is crucial for ensuring the financial stability of insurance companies in the face of evolving market challenges.