There is an old adage that “adversity builds character.” However, before adversity builds character, it reveals character, and the numerous catastrophes that have occurred over the last several years combined with the ongoing pandemic have clearly revealed the character of the insurance industry.
And there is a lot to be proud of in how well the industry has responded time and again to numerous crises. The (re)insurance sector is well-versed at navigating market-changing events, and while the impact of previous shock events such as Hurricane Andrew, the terrorist attacks of September 11, 2001 and Hurricane Katrina may have resulted in a loss of capital and reduced capacity in the short-term, the market responded to each occasion by innovating, working with governments and attracting more capital in the long term. Since 2017, catastrophe claims in the United States alone have totaled USD 214 billion. Despite that, the capital supporting the reinsurance sector has risen to a near all-time high of USD 471 billion, according to John Trace, CEO, North America, Guy Carpenter, and Jay Dhru, Global Head of Business Intelligence, Guy Carpenter.
Spotting the Black Swans on the Horizon
While it is important to think about black swan events, putting too much time and effort into planning for a specific event at a specific time may be a fool’s errand. Despite being a known risk, a pandemic was not on the risk radar for many people prior to COVID-19. Even in those instances where a black swan event is identified, preparing for such a crisis during good times will always look more expensive. Therefore, instead of focusing on a specific event, (re)insurers are best served by maintaining capital resilience, access to liquidity, strong risk management, nimble operations and innovative thinking.
What a Decade This Year Has Been
The (re)insurance industry entered 2020 with a strong balance sheet, pricing tailwinds and abundant capital. The impact of COVID-19 was sudden and violent and even though the equity markets have recovered from the depth of the crisis, the Standard & Poor’s (S&P) property & casualty (P&C) index (down 13 percent year-to-date) still lags the broader S&P 500 (up 2.4 percent) recovery. Despite that, (re)insurers have raised approximately USD 28 billion in debt and equity so far this year and approximately USD 4 billion of capital is waiting on the sidelines to be deployed.
What Got You Here Won’t Get You There
Reserve releases have buoyed (re)insurer earnings for over a decade now. History has shown us that such an extended period of reserve releases usually ends in tears. On top of that, the Federal Reserve has communicated its desire to maintain lower interest rates for an extended period and rating agency S&P has been sounding the alarm on (re)insurers’ inability to meet their cost of capital for a number of years now. Going forward, in order to meet their cost-of-capital hurdles, companies will need to maintain combined ratios in the low 90s to account for a decline in reserve releases and investment income. At the same time, rating agencies continue to expect companies to hold significant excess capital in the face of macro-level uncertainties.
In response to these challenges, prices are rising and companies have the opportunity to develop innovative products to address emerging risks.
The Changing Nature of Risk
The COVID-19 pandemic and social unrest in 2020 remind us that the insurance industry's challenges might change on a year-to-year basis, but they will never end. COVID-19 may represent the vanguard of a series of public health crises arising out of climate change, income inequity, fraying social safety nets, demographic imbalances, resource shortages and increasingly stressed urban infrastructures.
The industrial world is in the midst of a series of seminal changes that will radically change the nature of risk. Two of these seminal changes are climate change and the Fourth Industrial Revolution, which both carry the potential to be engines of great promise as well as great peril.
Climate change is nurturing extreme weather events; hurricanes are now more intense and occur more frequently, the polar ice caps are melting, sea levels are rising and threatening coastal cities, wildfires are raging and flooding is commonplace. These extreme weather events are changing the nature of risk and are causing misery and significant amounts of insured and uninsured loss. From an insurance and reinsurance product design perspective, addressing climate change is more of a scale and cognitive bias challenge than a product design problem. The industry has a working understanding of the principles underlying the business model and the associated risks, perils, hazards and insured assets.
The same, however, might not be said of the Fourth Industrial Revolution. The insurance industry, on balance, may not have a deep understanding of the emerging digital technology risks and the associated opportunities, threats, perils and hazards. The insurance industry may also not appreciate the impact that narrow artificial intelligence (NAI) will have on everything, or the inherent risks associated with NAI. NAI will change the future of government, law, wealth distribution, civil rights, war and work; accelerate income inequity; and influence how we live and relate to each other.
In the Fourth Industrial Revolution, platforms have replaced traditional companies and intangible assets have replaced heavy machinery as wealth drivers. Ocean Togo's recently released July 1, 2020 intangible asset market study indicates that intangible assets make up 90 percent of the S&P 500’s USD 28.94 trillion market value. Apple’s market capitalization stood at nearly USD 2.3 trillion on September 2, 2020. The entire market capitalization of stocks in the Financial Times Stock Index (FTSE) 100 was valued at just under USD 2 trillion.
The intangible asset revolution presents an unparalleled opportunity for the insurance industry to develop new and complementary products and services. The insurance industry currently offers defensive and offensive intellectual property (IP) insurance and key man life insurance. More research and development work is ongoing to develop new products to protect the full range of intangible assets, including a company's research and development, intellectual capital, processes, patents, trademarks, franchises, goodwill, copyrights, IP, business-to-business offerings, brand, hard intangibles, data, non-revenue rights, relationships and public rights.
Capital & Innovation Will Lead the Way
The opportunities that lie ahead for the insurance sector are vast and complex and will require thinking about risks in terms beyond what is currently known and measurable. Intangible risk exposure is different: it is not geographically contained like a natural catastrophe and is not as explicitly calculable as a burning building. Once-in-a-lifetime innovation like this comes from a diversity of ideas, and insurers have the opportunity to be a leading beacon in the unrest sweeping our country. Having a workforce that reflects the world we live in is good not only for society but also for business.
Insurers will also need a significant amount of capital to support these growth opportunities and rating agency requirements. Companies will have to decide how much capital they want tied up to service the tail versus how much to deploy to capitalize more lucrative opportunities.
Solutions around customized, structured reinsurance products enable carriers to redeploy capital supporting prior years’ underwriting and provide protection. By leveraging their existing balance sheets, carriers can essentially access capital in a relatively cost-effective way. These solutions include adverse development covers, which are essentially excess of loss covers attaching at or above carried reserve levels and loss portfolio transfers, which generally attach at first dollar of carried reserves.
Guy Carpenter has extensive experience helping companies understand and manage the complexities of reserve risk from both a balance sheet and capital perspective. We work with clients to create tailored solutions that match insurers’ capital and risk levels for maximum efficiency. These solutions offer greater certainty in financial results, capital efficiency, and therefore greater opportunities for profitable growth. Our experienced team has collectively executed on transactions covering in excess of USD 25 billion of reserves over the years in every major jurisdiction. With vast actuarial, accounting, financial, underwriting, and market experience, the team delivers results to insurers large and small around the world.