Almost two decades ago a report of the technical committee of the Investment Sub-Committee of the International Association of Insurance Supervisors suggested, in essence, that government supervisors should become increasingly involved in supervising the day to day management of insurance companies. The ostensible purpose of such involvement was supposedly to safeguard the interests of policyholders. Since then, the suggestion has been adopted in many countries, including South Africa. Such suggestions are based on what Nobel Laureate economist Friedrich Hayek described as a ‘fatal conceit’.
Government supervisors are overly conceited if they believe they can be the protectors and saviours of investors in the modern technological age. Insurance is about the reduction and spreading of risk and one would therefore expect the risk-reduction mechanisms to be provided by companies who are in the business of risk-management and not by government supervisors.
Government's proper function, in the context of asset management, is to create an environment in which property is respected, contracts are enforceable, the judicial system is efficient and accessible, the courts make just decisions, and the law and its enforcement agencies provide effective protection against fraud. However, government's proper function does not include providing insurers with detailed prescriptions on how they should manage their businesses.
Governments worldwide and their central banks have tended to increase rather than reduce the level of uncertainty and risk in financial markets because of errors in the handling of their national currencies and macroeconomic policies. As Alan Greenspan pointed out when he was chairman of the Federal Reserve:
The recent market turmoil in some Asian financial markets, and similar events elsewhere previously, confirm that in a world of increasing capital mobility there is a premium on governments maintaining sound macroeconomic policies and allowing exchange rates to provide appropriate signals for the broader pricing structure of the economy.
These countries became vulnerable as markets became increasingly aware of a build-up of excesses, including overvalued exchange rates, bulging current account deficits, and sharp increases in asset values. In many cases, these were the consequence of poor investment judgements in seeking to employ huge increases in portfolios for investment. In some cases these excesses were fed by unsound real estate and other lending activity by various financial institutions in these countries which, in turn, undermined the soundness of these countries' financial systems. As a consequence these countries lost the confidence of both domestic and international investors, with resulting disturbances in the financial markets.
Mr Greenspan attempted to share the blame evenly between governments and the private financial institutions yet it was patently clear that the root causes of the respective crises in Thailand, Malaysia, Argentina and Mexico were inappropriate and reckless actions on the part of the governments and central banks of those countries, exacerbated by the imprudent activities of the IMF as lender of last resort. Leland B Yeager pointed towards a solution to the incipient problem of uncertainty induced by currency volatility and crises which create the greatest risks faced by insurers and their clients - risks that insurers find very difficult to manage:
Fundamental reform ... would avoid sudden unpredictable changes in policy regimes and in official transactions; it would hold down the scope of large centralised decisions, whose effects are harder to cope with than the gradually occurring cumulative effects of innumerable decentralized private decisions; it would replace the role of official big players on whose dominant decisions the changeable expectations of the public focus. It would provide money of stable or at least predictable purchasing power.
Although it is not my task here, I am tempted to describe how to achieve these results by getting money issue out of the hands of governments ...
Private management of perceived risks
As Yeager suggested, the ultimate solution to the problem of unstable and volatile currencies is likely to be the private provision of competitive currencies. Such currencies would be freely exchanged over national borders and would not be subject to control or manipulation by governments. Professor Hayek made a similar suggestion in his book Denationalisation of Money, published in the 1970s, in which he set out the benefits of having competitive private currencies.
Monetary policy has not improved in the last two decades. In fact, uncertainty and risk associated with poor and reckless monetary management by governments and their central banks has increased rather than declined.
Until fundamental reforms occur, insurers and investors are to a greater or lesser extent at the mercy of the vagaries of the macroeconomic policies, including monetary policies, followed by the governments and central banks. Where there is exchange control, such as in South Africa, the risk is infinitely greater as insurers are prevented by the controls from adopting such risk-minimising strategies as would otherwise be available to them. A government with a real concern for the interests of policyholders would abolish exchange controls without delay.
Private, independent, and competing rating agencies are the best potential source of information for investors on the risk-profile of insurers. If the ratings were to be published they would be freely available to the investor public and insurers would be motivated by the public relations value of a good risk-rating to pay for the evaluation.
Both rating agencies and insurers would have their reputations at stake and would lose business if they failed, in the case of the rating agencies, to provide accurate ratings, and in the case of insurers to maintain ratings that provide investor confidence.
Government agencies create additional risk
An attempt by government to usurp a function that should be performed by private agencies will retard the development of institutions that can most effectively perform the desired risk-reduction function. For a great number of investors this delay is likely to prove costly and even catastrophic.
Strict controls, inspections, reporting requirements and similar measures that require an enormous bureaucracy give the public an illusion of safety and give some private institutions a respectability they are not entitled to. Investors often become aware that they are at risk when the institution is declared insolvent whereas a market-driven system would alert them well in advance. Civil servants with minimal down-side risk in the case of errors are no substitute for private risk-assessors with their careers and their companies' reputations and continued existence on the line.
Charles W Calomaris had this comment to make:
Throughout history, financial collapses have been defining moments for public policy. Crises promote action, embodied in new financial institutions or policy doctrines. The motives that underlie such policies are sometimes short-sighted - driven by short-run pressures rather than long-run principles - and it is easier to enact unwise policy in the midst of crisis than to reverse the course after the crisis has passed, after policies become embodied in institutions or statutes.
Professor Calomaris was writing about the "IMF's imprudent role as lender of last resort". He pointed out that IMF intervention has magnified moral hazard by lending legitimacy to domestic bailouts and insulating foreign creditors from losses. The IMF, he says, is undermining the natural process of reform in emerging economies when it insures foreign creditors who fuel developing economy risk-taking. In the same way, government insurance supervisors who attempt to usurp the functions of private risk-assessors and market mechanisms for risk-spreading create increased risks for investors over the longer term.
The proposals by the International Association of Insurance Supervisors for increased bureaucratic control over insurance companies were not based on sound economic principles and were therefore fundamentally flawed. Implementation of the proposals has imposed greater costs on insurance companies, decreased returns to policyholders and increased their risks.
Author: Eustace Davie is a director of the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the FMF.