Regulators should focus on insurers' role in markets outside their traditional sphere as such activities could worsen the economic impact of companies in the sector going bust, the global insurance watchdogs' association said.

But the industry's traditional insurance operations pose little threat to the wider economy or to the stability of the financial system, the International Association of Insurance Supervisors said in a report on Tuesday.

There is little evidence that traditional insurance generates or amplifies systemic risk within the financial system or real economy, Peter Braumuller, chairman of the IAIS financial stability committee, said.

However, supervisors need to monitor very closely those insurance activities that deviate from the traditional insurance business model.

The IAIS report could reinforce insurers' efforts to win exemption from capital controls aimed at preventing a re-run of the 2008 crisis, when close interconnections between lenders created a domino effect of bank failures, paralysing financial markets and slashing economic growth.

The industry's position also won backing from European Central Bank Executive Board member Peter Praet on Tuesday, who said that insurers are a source of stability in the financial markets because of their long-term investment horizon.

They are systemically important but they are not, we believe, systemically risky. It's very different from banks, Praet said at a financial conference in Frankfurt.

The near-collapse in 2008 of AIG and reinsurer Swiss Re has convinced some that the industry should be subject to tighter controls alongside the banking sector, seen as the primary culprit in that year's financial meltdown.

The IAIS said the biggest threat to stability from the insurance sector lies in its involvement in innovative financial products and services which tie it in more closely with banks and other financial firms.

These include issuance of insurance-linked securities such as catastrophe bonds, providing time deposit insurance, and writing credit default swaps, a form of insurance against credit losses.

AIG and Swiss Re's financial problems three years ago were driven by heavy exposure to credit default swaps written by specialised subsidiaries that operated apart from their mainstream insurance divisions.

The IAIS said insurers have retreated from the credit default swaps market, selling just $4 billion (2 billion pound) of the instruments in 2010 compared with a high of $20.3 billion in 2003.

Mainstream insurers mostly survived the 2008 crisis in better shape than banks because their customers pay premiums upfront and are not able to withdraw their cash overnight, the IAIS added.

(Reporting by Myles Neligan, Additional reporting by Jonathan Gould in Frankfurt; Editing by Jon Loades-Carter)