When we think of the U.S. insurance business, we usually think of companies that sell life, auto, or homeowner policies. The conventional wisdom is that these traditional insurance activities are regulated by the states largely to protect individual policyholders and should not be a concern to the Federal Reserve, whose regulation of banks is intended to protect the nation’s overall financial stability.

However, as became clear during the emergency bailout of the insurer American International Group (AIG) during the financial crisis in 2008, some insurance companies also engage in nontraditional activities, such as selling credit default swaps or lending securities, that could pose a threat to financial stability. The AIG episode has led some to suggest that the Fed should become involved in the regulation of large insurance companies.

How could an insurer pose a threat to financial stability? While there are many reasons that an institution could pose a threat to financial stability, two factors seem key. First, the institution’s activities leave it vulnerable to large losses that it cannot handle. Second, those losses are capable of spreading to the rest of the financial system via a domino effect, or contagion.1 As we will see, traditional insurance activities do not satisfy these criteria, but nontraditional activities do.

This article appeared in the First Quarter 2018 edition of Economic Insights. Download and read the full issue.

[1]To learn more about some of the channels of contagion, read my Business Review article on financial contagion and network design.