OFR advocates prediction markets to help identify systemic risk issues old-school monitoring might miss

Nov. 19, 2020 — The Office of Financial Research is telling the U.S. Congress that the development and use of information markets as a tool for anticipating and managing financial systemic risk would be a valuable complement to the current surveillance system.

In light of the fact that two and a-half dozen high-profile financial stability reviews 2019 failed to recognize a potential pandemic as a threat, conventional monitoring can come up short, according to the OFR, an arm of the U.S. Treasury Department.

“The pandemic illustrated the difficulty for conventional financial stability monitoring to identify true vulnerabilities,” the OFR’s annual report stated.

An information or “prediction” market for systemic risk, where participants who have superior information are rewarded financially while weaker-sourced individuals who wager lose could help reveal hidden information that might forecast or contribute to financial risk, the OFR suggests.

This information might otherwise be costly to ferret out or retrieve, the report’s authors say.

Information or prediction markets are a type of informed wagering with trading done between and among parties looking to make money off the outcome of the way an event breaks or what happens in the future to any number of scenarios. Major U.S. corporations have used them but regulatory barriers remain for wider use, apparently.

“Information markets might facilitate a more suitable allocation of those risks, and thus reduce the chance for systemic crises to emerge,” the paper states. They may also make a market more resilient, as well, according to the thinking, based on some renowned economists’ theories.

Such markets can help to produce forecasts of event outcomes with a lower prediction error than conventional forecasting methods and have been shown capable of producing more accurate and timely signals of weakening financial stability,” argue academic articles, as quoted by OFR. Other citations follow with the same general thesis.

The OFR, which was created under the Dodd-Frank Act a decade ago with a charge to give a report annually to the federal legislators that created it, also noted the obvious — that COVID-19 pandemic has affected all systemic risk categories and increased overall market uncertainty.

The categories the OFR deems high risk now are macroeconomic risk, with potential inflation caused by government intervention and credit risk from highly leveraged corporations, with the potential for defaults and bankruptcies.

Market risk is elevated, but not high, with help from the Federal Reserve, but that could change if valuations rise for not-so-healthy assets, the paper warned.

On the moderate risk scale are liquidity and funding, also helped, along it the markets, by the Federal Reserve’s stabilization efforts, according to the OFR. This also could change.

However, codependence between large providers and users of short-term funding remains a key vulnerability.

On the low end of the risk assessment scale is leverage in the financial system itself, while insolvency and octagon risks “appear contained,” the OFR said. Fortunately, leverage in the U.S. financial system has been restrained since the last financial crisis.

For insurers and banks, the capital buffers now in place “appear to provide an adequate cushion for unexpected losses” in the short term, at least.

The risk posed by cybersecurity threats, natural disasters, Brexit and the transition this fall to alternative reference rates from the old LIBOR system are also potential vulnerabilities are for financial stability overall, the OFZR notes.

The paper also mentions the development of quantum computing presents a longer-term risk.

NAIC to discuss examining insurers’ use of data & potential oversight of 3rd-party vendors in confronting racial inequities in p/c sector

The Special (EX) Committee on Race & Insurance formed by the organization state insurance commissioners to reckon with barriers to diversity, accessibility and inclusion in the insurance sector is starting its work by posing many questions on current practices and data use.

While answers may be on the long-term horizon, regulators are digging into insurers’ manifold use of data and data mining — and even considering their own collection for future analysis, to help achieve racial equality.

The National Association of Insurance Commissioners is wrestling with a path forward on equitable application of all elements of insurance, from underwriting practices to hiring to analysis to agent licensing requirements.

One of the most far-reaching areas where regulation meant to ensure racial equality and fairness could potentially expand in a now data-driven world is in the use of this wealth of information.

Based on an NAIC list of potential issues for the special committee to consider in the property casualty sector is future regulation of third party vendors that create algorithm for pricing.

“Third-party vendors are often not licensed as advisory organizations in the states. These vendors provide supplementary rating information and rating and scoring models for clients but do not file with states,” the Oct. 29 NAIC document says.

The discussion list is part of the NAIC’s materials for a public discussion of p/c subject material Nov. 12. The p/c arena is one of five work-streams under the purview of the NAIC’s special executive level committee. These work-streams are listed below.

The NAIC could also consider collection of information from insurers in order to monitor discrimination and/or disparate impact on communities, according to the discussion points listed.

Another practice state regulators might examine is claims settlement.

For example, some commissioners of insurance might want to know if fraud detection techniques unfairly discriminate by using prior convictions which may be impacted by policing practices.

Regulators will also be discussing access to insurance among disadvantaged groups, and examine the affordability of auto and homeowners insurance looking at past studies and history compiled on the subject. The online shift of insurers and its effect on reaching economically disadvantaged groups will also be probed.

Details for the Thursday meeting are here.

The NAIC is also hosting a public call Nov. 18 to hear from interested parties on work-stream one.

This category includes discussions and statements on the current level of diversity and inclusion within the insurance industry, practices or barriers that potentially disadvantage people of color and/or historically underrepresented groups, steps state regulators and/or the insurance industry can take to increase diversity and inclusion and address practices that potentially disadvantage people of color and/or historically underrepresented groups.

The special committee’s five work-streams, based on the the NAIC’s website, are:

Work-stream One:
Research / analyze level of diversity and inclusion within the insurance industry. Make recommendations on action steps.

Work-stream Two:
Research / analyze level of diversity and inclusion within the NAIC and state insurance regulator community. Make recommendations on action steps.

Work-stream Three:
Examine and determine which practices or barriers exist in the insurance sector that potentially disadvantage people of color and/or historically underrepresented groups in the p/c line of business. Make recommendations on action steps.

Work-stream Four:
Examine and determine which practices or barriers exist in the insurance sector that potentially disadvantage people of color and/or historically underrepresented groups in the life insurance and annuities lines of business. Make recommendations on action steps.

Work-stream Five:
Examine and determine which practices or barriers exist in the insurance sector that potentially disadvantage people of color and/or historically underrepresented groups in the health insurance. Make recommendations on action steps.