Insurers are not Banks: Assessing Liquidity, Efficiency and Solvency Risk Under Alternative Approaches to Capital Adequacy

Abstract

Differences in the portfolios of depositories and insurance and reinsurance firms are important for the design of efficient capital regulations. Using a simple contingent claims model which focuses on credit risk and in which intermediaries issue liabilities under conditions of moral hazard, we illustrate three effects of risk-based capital regulations on institutional solvency risk, liquidity and economic efficiency. First, assuming identical asset risks to depositories, insurers that issue significant amounts of contingent liabilities may exhibit a zero risk of insolvency while holding significantly less equity capital than depositories. Second, higher capital requirements must be placed on depositories to attain the same degree of solvency risk, owing to the riskless payoffs promised for bank deposits and similar liabilities. Third, while bank-based capital regulations cannot resolve losses associated with systemic financial risk, capital regulations that incorporate incentive-compatible tax penalties to mitigate moral hazard effects can do so by increasing both liquidity and spanning. We conclude that distortions occur when measuring the solvency risk of insurers and other non-bank intermediaries with bank-based capital regulations and that uniform harmonization of capital regulations across depositories and insurers can significantly reduce aggregate liquidity and efficiency.

Basel III Versus Solvency II: An Analysis of Regulatory Consistency Under the New Capital Standards

“…Darlap and Mayr () and Flamée and Windels (), for example, describe the importance of the regulatory efforts to achieve equal treatment of financial sectors. In line with this reasoning, Monkiewicz () and Herring and Carmassi () discuss the possibility of an “integrated supervisor.” On the other hand, Mälkönen (), Kupiec and Nickerson (), and Freixas, Lóránth, and Morrison (), among others, argue that divergences and arbitrage opportunities can increase efficiency and social welfare under certain circumstances.…”

“…In line with this reasoning, Monkiewicz (2007) and Herring and Carmassi (2008) discuss the possibility of an "integrated supervisor." On the other hand, Mälkönen (2004), Kupiec and Nickerson (2005), and Freixas, Lóránth, and Morrison (2007), among others, argue that divergences and arbitrage opportunities can increase efficiency and social welfare under certain circumstances.…”

The Implications of Prompt Corrective Action for Insurance Firms

“…Harrington does not specifically discuss financial guaranty insurance, which may be a noteworthy exception in light of current developments. 20 See alsoKupiec and Nickerson (2005), who demonstrate analytically that assuming identical asset risks, the amount of capital needed for an insurer to achieve a low level of insolvency is lower than for banks. They conclude that harmonizing capital requirements across banks and insurers could significantly reduce aggregate liquidity and efficiency Epermanis and Harrington (2006).…”