Financial Insurers Prove that Capital Rules Work

In a recent Comment, Peter Cooke, former chairman of the Basel Committee of Banking Supervisors, noted that the banking and insurance industries are drawing closer together.

Though this trend broadens and deepens the market for financial services, it also raises a host of new issues for regulators, including the interaction of different supervisory regimes and related questions of competition and level playing fields.

At the heart of the matter is a basic issue: Do these businesses have enough capital to support the risks they take?

Regulators worldwide are focusing on this broad issue, attempting to set guidelines to ensure that financial service companies have adequate capital.

A Many-Sided Effort

In the banking industry, for example, the Basel supervisors committee, which brings together the bank supervisors of the G-10 countries, has proposed risk-weighted capital guidelines that are being widely introduced by bank regulators throughout the world.

In the securities industry, the Basel supervisors committee, the European Commission, and the International Organization of Securities Commissions are all working to devise similar rules for banks and nonbanks involved in the securities business.

Meanwhile, in the U.S. insurance industry, the National Association of Insurance Commissioners is drafting risk-based capital rules for property-casualty and life insurance companies.

Against this background, it is noteworthy that rules of this kind have applied to the U.S. financial-guarantee insurance industry for some time. Risk-based capital requirements are a key element of Article 69 of the New York Insurance Law, which governs the financial guarantee industry.

Experience so far with this rigorous regulatory framework demonstrates how effective such arrangements can be. In an era of excesses in certain parts of the financial services industry, this specialist sector of the insurance business has been a good example of moderation.

Municipal Bonds Were First

Financial guarantee insurance is a long-established method of enhancing the marketability of specific categories of debt instruments.

Municipal bond insurance is traditionally the most widely used form of financial guarantee insurance. Beginning in the mid-1980s, however, financial guarantee insurance has also been increasingly used in the United States and Europe to provide credit enhancement for a variety of asset-backed securities.

Financial guarantee insurance unconditionally guarantees the full payment of principal and interest on a debt instrument. The premium for the insurance is offset by the interest rate savings resulting from the higher credit rating conferred by the guarantee.

As most U.S. financial guarantee insurers operate in New York, they are subject to the provisions of Article 69.

An important aspect of the law is to confine the activities of separately capitalized insurance companies to a narrow range of related activities, insuring high-quality municipal or asset backed transactions.

In the municipal area, securities must be supported by strong tax-paying authorities. For asset-backed issues, multiple layers of protection are required, such as overcollateralization or other third-party guarantees.

Article 69's regulatory thrust is to contain single and aggregate exposures by setting limits expressed as a percentage of capital and by creating reserves against such insured obligation. These regulations are similar in approach to the Basel guidelines on capital adequacy measurement for banks.

Investments Monitored

Under Article 69, financial guarantors' investment activities are also strictly monitored and limited to permitted investments.

Moreover, the success of this stringent regulation and the tight controls exercised by the insurers themselves has been evidenced by the financial guarantee insurance industry's low loss rate - 0.009% of outstanding par value insured.

It will be important that these standards are maintained as markets change and the technique of financial guarantee insurance is applied in innovative ways.

Risk-based capital rules are not a panacea for restoring or maintaining the health of financial service companies. Many other aspects of regulation, such as controls over entry to the market, the quality of management, limits on concentration of risk, and checks on the adequacy of systems and controls are also important. Management attitudes toward risk control are equally critical.

Nevertheless the low loss rate of the financial guarantee industry - which is rated triple-A- - provides encouragement that stringent risk-based guidelines can be applied effectively to a broad range of financial service organizations.

Mr. Brown, until recently a management consultant with Price Waterhouse, London, is a director of the Ouverture Project, a European Community program.

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