Insurance companies' balance sheet is different from the classic bank model. Where banks write investments like loans or bonds in the asset's part, Insurance companies write the asset they have insured in the asset side and in counterparty, they write a provision in the liability side.
This is Bank of America latest Consolidated Balance Sheet. It is obvious that in order to lend money, the bank uses the deposits. But deposits are not the bank property and should not be in risk. If there is a credit default or a market risk or an operational risk, the called “capital tier 1 and 2” should cover that risk. And we all know that the Basel II capital requirement is 8%. Here the shareholders' equity is $177 billion. This amount should represent more than 8% than the assets in risk.
For an insurance company, we took the AIG balance sheet. In order to insure an asset, an insurance company does not need the asset value in deposit. They just calculate the risk and establish a premium. This is why they can make high leverage because the investment for insuring is closed to 0. We will discuss that later and focus on the CDSs cases at AIG. After receiving a premium, the insurance company invests it in order to generate investment income. Here, in our case, we see clearly that AIG is well involved in the bond market. More than 60% of the fixed assets are invested in bonds. And these same bonds held by other investors are insured by….. AIG!
If the bond issuer defaults, then AIG is in double risk: They have to pay for the policy holders.
Second risk: They lose the asset. Do they have sufficient reserve to handle that scenario?
This is AIG liabilities and it is obvious that the shareholders' equity of almost 100 billion won't cover such a scenario. This topic will be discussed later.
The policy holder contract deposits represent the deposits that can be used in case of risk. But if we compare it to the bank of America deposits, the percentage of deposits in the liabilities is too low for AIG. In order to conclude our bank and Insurance balance sheet comparison, we can say that the Insurance companies are less regulated and a high loss scenario would be fatal.
The main reason is that in order to finance fixed assets, you should have fixed liabilities. That is exactly what banks are doing with deposits in order to finance loans. When you look at AIG balance Sheet, the fixed liabilities are not sufficient in order to finance the fixed assets. Moreover, the fixed liabilities of AIG should also finance an eventual risk
The capital quality of solvency II should be respected.
The low quality (Tier 3) should not exceed one third of the total capital.
Secondly, the Solvency Capital Requirement corresponds to the economic capital a (re)insurance undertaking needs to hold in order to limit the probability of ruin to 0.5%, i.e. ruin would occur once every 200 years.
This means than each Insurance company should have its own capital requirement according to the risk they are taking.
We saw previously how AIG was in danger before the crisis. This can be explained by the rapid growth of CDSs market.
Normally, an insurance company manages the risk using premium. They calculate the risk likelihood and establish a premium that cover that risk and allows the company to make profit. In the CDS's market, the risk does not work that way.
For example, in normal cases, if your neighbor house is burnt, the likelihood that your house will also burn is independent. In the CDS market, the risk is not independent, it is exponential.
When there is one big credit default (bonds), it is contagious and the market is affected by that. We will have more and more credit defaults and a CDS insurer won't be able to face it. The premium strategy won't work. This is not the same risk evaluation.
This is exactly the reason why AIG asked for help from the US government during the crisis we are facing. They were not able to pay all the policy holders because the amount of credit defaults was too high.
To go further, we will be interesting to know how we can regulate the CDS market knowing that the normal formula listed in solvency II does not work for an exponential risk.
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