In this piece, JOSEPH INOKOTONG writes on how market discipline can help implant a culture of compliance and accountability in the insurance industry.
MARKET discipline can be a powerful force for promoting a culture of compliance and accountability in insurance.
According to experts, market discipline is the process by which market participants such as uninsured lenders, shareholders and rating agencies monitor the risks and financial positions of banks, insurance firms, etc, and take action to guide, limit and price banks’ risk-taking.
A few ways which market discipline can help instill a culture of compliance and accountability include reputation because insurance companies that do not follow regulations or engage in unethical behaviour can suffer damage to their reputation, which can lead to a loss of customers and market share.
Another is financial consequences. Insurance firms that violate regulations can face fines and other financial penalties, which can impact their profitability.
Consumer power: Customers have the power to choose which insurance companies to do business with.
However, for market discipline to work effectively, market participants must have the information, the means and, most importantly, the incentives to monitor and influence insurance firms to limit excessive risk-taking.
The global financial crisis highlighted the weaknesses in regulatory regimes to supervise and resolve large financial institutions, the World Bank pointed out.
These systemically important financial institutions (SIFIs) have been deemed as too big, too interconnected, and too complex to fail by domestic authorities because their failure would significantly disrupt the financial system and economic activity, governments worldwide have made unprecedented interventions in the markets to rescue these large financial institutions using public resources.
As a result of these measures, shareholders and insurers have been able to shift bank losses to taxpayers to mitigate total loses.
These interventions rekindled the debate on the impact of government interventions on market discipline and on the incentives of owners, borrowers, and shareholders to monitor large financial institutions. The focus of the regulatory reform agenda has also been shifting from supervision to resolution. In the case of the financial institution, a strong resolution regime, in which bank creditors bear the brunt of losses, is considered to be important to reinforce market discipline.
Market discipline refers to the notion that market participants, such as uninsured lenders, shareholders and rating agencies, can influence either an insurance firm or a financial institution’s behaviour through monitoring its risk profile and financial position. By making risk-taking costlier, market discipline has been recognised by regulators as an important mechanism for curbing insurers’ incentives to take excessive risks.
Market discipline was introduced as the third pillar of the Basel capital regulations as a way to complement and support official oversight of financial institutions through new public disclosure requirements, the World Bank stated.
For market discipline to be effective, market participants should have not only the means to monitor the activities of insurance companies and others but also the ability to influence and impose discipline on these institutions.
According to Bliss and Flannery, the two main components of market discipline are monitoring and influence. Monitoring is the process by which insurers, shareholders, depositors and other market participants can systematically review the business activities, financial condition, and risk-taking behavior of the entities. Influence can be both direct and indirect.
Market participants, based on their monitoring, can take direct corrective action. This action can be in the form of refusing to roll over short-term debt, charging higher interest rates on new debt, or exercising covenants on debt contracts, in the case of banks.
Indirect influence occurs when a third party, responding to the information provided by market monitoring, engages in corrective action. For example, wholesale funding may be withheld based on external assessments by rating agencies, or, if the institution has publicly traded securities, the market’s risk assessments can be inferred from the observed security prices and funding may be withheld based on security prices.
Effective market discipline requires two important conditions. First and most important, market participants must have incentives to monitor. Large depositors, shareholders and other unsecured creditors naturally have incentives to monitor banks because they have money at stake. Empirical evidence indicates that the amount of uninsured and subordinated debt banks carry on their balance sheets is associated with greater market discipline, according to Flannery and Sorescu, and Sironi.
Second, market participants must have access to relevant and timely information. It is difficult for uninsured debt holders or shareholders to effectively monitor their investments unless they receive reliable financial information about the institutions in which they are investing. Stringent disclosure rules, independent outside audits and the availability of public and private credit ratings all increase transparency and allow for greater discipline by market participants.
For instance, information availability and information asymmetry in the banking sectors are important drivers of systemic risk. The importance of information in market discipline has also been recognized by the Basel Committee on Banking Supervision (BCBS).
The growing complexity of organisational structures and operations of large institutions makes it difficult for market participants to process information. The rapid development of new financial instruments over the last two decades has increased the complexity and opacity of bank balance sheets. At the same time, institutions are now structured as intricate ownership hierarchies, involving hundreds or thousands of legal entities that span multiple sovereign nations.
Their multiple business lines range from insurance to investment management and they receive a substantial portion of their income from noninterest activities.
Market discipline can be enforced in several ways like government regulation. Governments can enforce market discipline by setting regulations and standards for the insurance industry and enforcing these regulations through fines and other penalties.
It can also be checked through industry self-regulation. Insurance companies can work together to set standards for behaviour and compliance and enforce these standards through self-regulation.
Consumer activism is another way of curtailing the vice. Consumers can play a role in enforcing market discipline by choosing to do business with companies that follow ethical and compliant behaviour.
However, there are other ways to achieve results without taking punitive measures. Punitive measures are not the only way to achieve results in promoting a culture of compliance and accountability in insurance. Other potent alternative approaches include incentivisation, where insurance companies can be incentivised to follow regulations and behave ethically through rewards such as tax breaks or other benefits.
Education and training is another. Insurance companies can invest in education and training programmes for their employees to ensure they understand the importance of compliance and ethical behaviour.
Also, raising public awareness about the importance of compliance and accountability in insurance can help to create a culture of compliance and accountability.
A few more things that might be considered on promoting compliance and accountability in insurance include the culture of compliance. Insurance companies can create a culture of compliance by emphasizing the importance of following regulations and ethical behaviour in all aspects of their business.
Technology can be used to help promote compliance and accountability in insurance by automating processes and making it easier for insurance companies to stay compliant.
Also, insurance companies can demonstrate their commitment to compliance and accountability through corporate social responsibility initiatives.
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