One of the more controversial aspects of Dodd Frank was whether or not large, multi-billion dollar insurers should be subject to capital constraints reserved for large banks. One interesting op-ed suggests that AIG should not be. According to Bloomberg’s Stephen Gandel:
Giant insurers, despite their size and important role in the economic system, probably don’t deserve to be on the SIFI list in general. Banks can cause shocks to the economy because they both need constant liquidity and add to the pool of available money. Insurers, unless they write a lot of financial derivatives, generally do not have the same sudden liquidity shocks. Furthermore, the Trump administration’s regulatory rollback agenda includes shrinking the number of firms on the SIFI list, and many are already betting that insurers will drop off relatively soon.
Well, I’d have to say that the desire of any administration to “rollback” regulations is not, in itself, a sufficiently strong policy basis for removing SIFI designations. That said, the observation that insurance firms do not exhibit the same asset liability mismatches and fragilities as banks certainly makes a valid point. Because insurers don’t have demand deposit creditors, they tend to be more stable. Moreover, insurers are not part of the financial payment system and interact primarily with consumers, limiting their interconnectivity.
Still, insurers are financial intermediaries, and if a significant-enough risk they underwrite materializes, their failure could conceivably undermine the health of the financial system. And the risks for large scale insurers like AIG are in some ways diversifying, even as they have exited many of the derivatives transactions that helped spark the financial crisis. One increasingly prominent risk, as Mr. Gandel smartly acknowledges, is climate change:
[C]limate change… appears to be contributing to more hurricanes and other natural disasters and consequently more potential insurance losses. Two Category 3 storms have not hit the mainland U.S. in a single year in more than a decade. Estimates for total damage from Irma are as high as $130 billion. Reinsurance and catastrophe bonds are supposed to spread the risk, much like securitization and derivatives were supposed to in the housing market[…]. And the failure of a reinsurer could cause the failure of a number of other insurers. The SIFI designation, after all, is not solely about whether a firm is at risk of failure but what happens when it does.
Still, the article argues that 1) hedge funds are taking on an increasing chunk of reinsurance risk and 2) if Irma doesn’t cause a failure, AIG in particular would be in a good position to argue that it should not be subject to a SIFI designation.
I personally think the jury’s still out. Hedge fund participation in fact has reportedly diminished the last several years due to the relative lack of major natural disasters and now, as the risk tied to the bonds becomes more evident, institutional investors conversely are concerned about prospects of taking total losses on their investments as the storm season gears up. Furthermore, basing a policy change of this importance on the outcome of one natural disaster—and the luck (or absence thereof) associated with Irma’s random path—seems like a poor, and unscientific way of thinking through policy where threats like super storms are only likely to become more destructive.