In a speech in November 2009, ECB President Jean-Claude Trichet argued that insurance companies and pension funds are “systemically important” (i.e. key to the smooth functioning of the global financial system) for three main reasons, namely “their size, their interconnectedness and the economic function of insurance.” (See the full text of the speech [PDF, 49K].)
He pointed out that it is difficult to overstate the scale of these two components of the financial services sector. “Collectively within the euro area, their investment amounted to six trillion euros at the end of June 2009,” he said. Moreover, this is a trend that the growing role of fully funded pension schemes worldwide can only serve to increase.
Generally speaking, this is a good thing and works to ensure the stability of the global financial system and the stability of national financial markets. However, Trichet points out that the portfolios of the various pension funds and insurance companies are so massive that when some of them decide to unwind their positions—for example, to bail out of emerging markets, or out of banking stocks—they can send markets into a tailspin.
The implicit logic here is that if a couple of major funds start dumping stocks and a significant proportion of the rest catch the scent and follow suit, large swings in asset prices follow. If this happens in a modest way, it creates additional market volatility, and that tends to settle down fairly quickly if there are no major macroeconomic reasons driving the decision. If there are good strong macro reasons for the move, then you get a tsunami and the markets can get swept away big time. Usually, exchanges steady things down when this happens by calling a halt to trading to calm the hysterics.
Thus far, of course, the ECB president wasn’t telling market traders anything they didn’t already know. The educational component of his speech comes from tying this point to the two subsequent ones, concerning interconnectedness and the role of insurance. The interconnected point is where it starts to get scary. Euro area insurance companies and pension funds hold around €453 billion of debt securities issued by euro area banks. That’s close to 1/12th of their total portfolio and it’s big enough to make everything get wobbly if the banks start falling over.
In central banker speak, it means that the regulators have to get their wheels in motion to work out the implications of the potential transmission of problems from one sector to another, since the mechanisms for contagion are most certainly in place. Why does this matter? At the extreme bound, think failed pension funds and no insurance capacity, ergo, no trade, period, with riots in the streets and society coming unglued.
However, just because things can fall over doesn’t mean that they will fall over. The new EU supervisory architecture involves the establishment of a new European Systemic Risk Board (ESRB). It also calls for a single pan-Europe rulebook, instead of the current system where each nation enacts the legislation with its own wrinkles and twists. And it looks for great cooperation between colleges of regulatory supervisors.
In theory at least, this should mean that the kind of widespread mispricing of risk that underlay the last crisis will be spotted and acted on earlier in future. Of course, generals are notorious for fighting the last war instead of the present one and it remains to be seen if the old axiom holds true for regulators as well.
There are already some whispers that the next crunch could come from a sovereign debt-inspired crisis, which, of course, lies at a meta level partially outside the powers of the new regulatory framework. If their political masters are the ones pushing the boat out, what is a regulator to do?
Further reading for insurance companies in the markets
- Insurance—Bruised, Not Crushed, by Robert P. Hartwig
- Climate Change and Insurance, by Stephen Haddrill
- Solvency II—A New Regulatory Framework for the Insurance Sector, by Paul Barrett
Tags: EU , insurance , Jean-Claude Trichet , market instability , pension funds , regulation