October 2011

The Emerging Role of Macro-Prudential Surveillance in Insurance Supervision

In the wake of the global financial crisis, the term "macro-prudential" has become increasingly popular in policy circles. One of the key lessons learned from the recent crisis is that regulation with a greater macro-prudential focus—which goes beyond supervision at the individual firm level, or a micro-prudential perspective—was a missing element of the existing regulatory framework. However, while use of the term macro-prudential in research papers, policy speeches and international forums grew considerably during the height of the recent crisis, progress in developing a macro-prudential surveillance framework is in its infancy. In addition, most of the early literature on macro-prudential surveillance has focused primarily on the banking industry, not the insurance industry. This article will discuss the buzz behind the term macro-prudential and why its emerging role is important in insurance supervision.

• Background on the Term “Macro-prudential”

The first use of the term macro-prudential dates back to the late 1970s. The Cooke Committee (the forerunner of the present Basel Committee on Bank Supervision) used the term at a meeting in 1979 where concerns over the financial system's stability and its link with the macroeconomy were discussed.[1] During this time, it became apparent that regulating only individual institutions was not sufficient to ensure financial stability. Historically, supervisory authorities have been entrusted with the responsibility of ensuring the protection and solvency of individual financial institutions in order to protect individual depositors, investors or policyholders, and did not have direct responsibilities for stability of the financial system as a whole.

Financial crises in the late 1990s, particularly the Asian financial crisis, drew attention to the interdependence between the macroeconomy and the financial system, and emphasized the need to build resilience to systemic shocks. Since then, usage of the term macro-prudential has become more common in banking policy circles. In 2005, the International Monetary Fund (IMF) Handbook described a sound and well-functioning financial sector as one built on three pillars needed for orderly financial development and sustained financial stability. One of the three pillars was macro-prudential surveillance and financial stability analysis, which was described as monitoring the effect of potential macroeconomic and institutional factors on the soundness (risks and vulnerabilities) and stability of financial systems.

Following the onset of the global financial crisis in 2008, the term macro-prudential became central in research related to strengthening regulatory and supervisory frameworks. Data from the search engine Google show that use of the term macro-prudential soared from less than 50,000 counts in 2000 to nearly 200,000 in 2009; while data from LexisNexis and Factiva show that use of the word went from zero to a little more than 2,000 in the same period.[2] A number of terms that begin with the word "macro-prudential"—such as macro-prudential policy, supervision, regulation, frameworks, indicators, monitoring, analysis, concerns, vulnerabilities and risk—are now being used with increased frequency in the discussion of the assessment of the health and safety of the financial system.[3]

However, although the term is more commonly used, a formal definition of macro-prudential policy remains ambiguous. This is partly because the objective of macro-prudential policy is largely informal, as there is neither a common framework nor a consensus on the indicators and instruments to be considered. In a recent IMF survey conducted in December 2010 that was sent to 63 countries and the European Central Bank, not one respondent had a formal definition of macro-prudential policy.[4] In a comment in the Financial Times on May 19, Howard Davies (director of the London School of Economics) and David Green (former head of international policy at the UK Financial Services Authority) said, "No one is yet clear, nationally or internationally, quite what this term [macro-prudential] involves."

• Macro- vs. Micro-prudential Perspectives

The financial system has become more interconnected and complex than ever before, making the impact of a crisis, in turn, greater than ever. As the recent crisis unfolded, stress in one institution spread quickly to related institutions, across sectors and across jurisdictions, creating systemic risk. The crisis showed that micro-prudential supervision alone was not enough to sustain the stability of the financial system. A more comprehensive macro-prudential approach is needed to look at the entire economy and the financial system to identify potential sources of system-wide risks prior to their widespread dissemination.

There are considerable differences between macro-prudential supervision and micro-prudential supervision with respect to their objectives, supervision methods and recognition of economic conditions (Table 1). These differences can have important implications for the diagnosis of threats to financial stability.

Table: The Macro- and  Micro-prudential Perspectives Compared

The focus of micro-prudential supervision is to protect financial consumers (i.e., investor/depositor/policyholder protection) with the objective of limiting the distress or losses at any one specific institution. On the other hand, the focus of macro-prudential supervision is on the financial system as a whole, with the objective of mitigating the costs of financial distress to the macroeconomy. While micro-prudential supervision is exclusively focused on individual institutions, macro-prudential supervision provides a holistic view of the sector in question and the overall economy.

• How Macro-prudential Surveillance can Improve Financial Stability

Through its enforcement of effective regulation of individual institutions, micro-prudential surveillance remains vital to maintaining financial stability. Macro-prudential surveillance is a complement to the existing micro-prudential approach, rather than a substitute for it. Together, macro-prudential and micro-prudential surveillance can better assist supervisors in their efforts to mitigate the detrimental effects of the risks identified.

Macro-prudential surveillance aims to mitigate the impact of systemic shocks by identifying macroeconomic and financial risks that could lead to a large number of financial institutions becoming insolvent or significant disruptions to vital parts of the economy. Macro-prudential risks can include trade imbalances, large capital inflows and outflows, asset market bubbles, interest rate risk, inflation risk, liquidity risk, sovereign debt risk and dramatic changes in market sentiment. Mitigating such risks is a key part of macro-prudential surveillance, thus improving the stability of the financial system and the overall economy.

• Macro-prudential Policy and Tools for the Insurance Industry

The awareness of the importance of developing a macro-prudential framework for supervision has grown substantially following the global financial crisis. The Group of Twenty (G-20) Finance Ministers and Central Bank Governors recently turned its attention to this area, calling on the IMF, the Bank for International Settlements (BIS) and the Financial Stability Board (FSB) to develop a macro-prudential policy framework.

While there has been progress in strengthening the macro-prudential orientation, a macro-prudential policy framework is still evolving. Federal Reserve Chairman Ben Bernanke said in May 2011 at the Fed's annual banking conference, "While a great deal has been accomplished since the [Dodd Frank] act was passed less than a year ago, much work remains to better understand sources of systemic risk, to develop improved monitoring tools, and to evaluate and implement policy instruments to reduce macro-prudential risks."

Most of the research examining tools and potential effectiveness of macro-prudential surveillance has dealt with the banking industry, not the insurance industry. Recognizing the vast differences between the two, the International Association of Insurance Supervisors (IAIS) recently created the Macro-prudential Surveillance and Insurance Working Group (MPSWG), under the Financial Stability Committee (FSC). The MPSWG is tasked with developing an insurance-specific macro-prudential policy framework, including macro-prudential tools to "identify, assess, monitor and mitigate the adverse consequences of systemic risk to be used by supervisors."

The MPSWG will also develop additional standards and guidance within Insurance Core Principle (ICP) 24. ICP 24—Macro-prudential Surveillance and Insurance Supervision— states that the supervisor should undertake a macro-prudential surveillance by monitoring and analyzing factors that may have an impact on insurers, insurance groups and insurance markets. ICP 24 also calls for the development and application of macro-prudential tools aimed to limit systemic risk as a result of, or increased by, activities in the insurance sectors.

As the MPSWG moves forward, it may be necessary to closely analyze how macro-prudential surveillance works for the banking industry. An important instrument for this in the banking industry has been stress testing. The recently concluded Supervisory Capital Assessment Program (SCAP), better known as the bank "stress test," is one example of how macro-prudential surveillance can be used in conjunction with micro-prudential perspectives in order to create a stronger regime that addresses a more complete range of supervisory objectives. SCAP is a financial system stress test on the nation's largest bank holding companies conducted by the Federal Reserve System to predict potential losses, the resources available to absorb losses, and the resulting capital buffer needed based on various economic scenarios.

Banking regulators have utilized macro-prudential or financial soundness indicators that fall into the general categories of capital adequacy, asset quality, market risk and liquidity. In addition to examining these indicators for relevance in the insurance industry, insurance supervisors may also want to identify industry-specific indicators that are important to macro-prudential surveillance. Some of these indicators unique to the insurance industry are the underwriting cycle of hard and soft markets and the pricing and availability of insurance products.

• NAIC Macro-Prudential Surveillance Efforts

The NAIC plays an active role in macro-prudential surveillance in the insurance industry. Various committees, task forces, and workings groups are charged with oversight and maintenance of specific segments of the U.S. solvency framework of regulation. These surveillance efforts include reviewing the performance of insurers with the goal of identifying industry-wide trends of significance and concern. The NAIC Financial Data Repository (FDR) database allows regulators to monitor the performance of the industry and identify concerns for further investigation. The NAIC Insurance Analysis & Information Services Department utilizes the FDR to perform quarterly analyses and reports that summarize the operating performance of each of the major insurance sectors. Such analyses helps identify macro-level risks and enhances the regulators ability to consider an appropriate response to risks at a micro-prudential level.

In 2009, the NAIC conducted top-down stress tests on individual insurance companies, where company-level data was aggregated to get a macro view of the U.S. insurance industry. The initial results of the stress test focused concern on the life insurance industry. Detailed investment stress scenarios were applied to the top life insurers' balance sheet results and input into the NAIC Risk-Based Capital formula. The potential industry impacts were assessed and used to focus regulatory attention on writers of specific products.

Furthermore, the NAIC Capital Markets Bureau (CMB) is charged to take a broader view of the impact of the capital markets on investments of the U.S. insurance industry as a whole, as well as of individual insurers. The CMB focuses on different sectors of the market in their entirety, as opposed to individual investments, and analyzes what could happen to those sectors. The CMB also reacts to current events, such as the Japanese earthquake, the Eurozone sovereign debt crisis, and the U.S. credit rating downgrade by Standard & Poor's. The analysis is feed into other areas of the NAIC as well as through a Special Report available on NAIC's website.[5]

• Conclusion

The global financial crisis has highlighted the need for developing a macro-prudential policy framework and the development of tools for identifying risks and trends in order to detect potential build-up of systemic risks. The IAIS has found that most insurance supervisors do conduct macro-prudential surveillance activities; however, the breadth, reach and frequency of activities varies from supervisor to supervisor. Going forward, insurance supervisors may need to expand their macro-prudential surveillance activities further in order to strengthen their regulatory framework.


[1] Clement, Piet, “The Term Macroprudential: Origins and Evolution,” BIS Quarterly Review, March 2010.

[2] Ibid.

[3] Chul, Park Yung, “A Macroprudential Approach to Financial Supervision and Regulation,” International Monetary Fund, October 2006.

[4] Viñals, José, “Macroprudential Policy: An Organizing Framework,” International Monetary Fund, March 14, 2011. ).

[5] Http://www.naic.org/capital_markets_archive.htm


Copyright © 2011 NAIC, All rights reserved.