The economic environment for reinsurers was difficult heading into 2020, largely due to persistently low interest rates.
“We said in our renewal report that we thought there was going to be a tightening of reinsurance capacity as 2020 progressed,” says Mike Van Slooten, head of business intelligence for Aon’s Reinsurance Solutions business. “If your investment returns are under pressure and you’ve been taking a lot of losses, it’s going to be very hard for you to cover your cost of capital, and that is going to provide an incentive to try to push pricing higher.”
Despite a variety of challenges, including increasingly severe natural catastrophes, reinsurance supply was largely sufficient to meet demand in all but the most constrained areas to start 2020, which was moderating risk-adjusted pricing movements, says Lara Mowery, global head of distribution for Guy Carpenter.
“Fast forward to the end of October 2020, right before the presidential election in the U.S., and we are facing the same issues, still, with also a record hurricane season still in progress and COVID-19 presenting completely new challenges for all of us,” says Axel Freiboth, managing director at Hannover Re for Property & Casualty Treaty North America. “The reinsurance treaty renewals that already occurred throughout the year 2020 certainly all point in one general direction — rates are going up, and terms and conditions are tightening. This trend will also continue for the January 1 renewal.”
Gobsmacked by COVID-19
The possibility of a global pandemic seemed unlikely just 12 months ago. From an insurance-industry perspective, more thought was dedicated to potential impacts on the life and health side of the equation, and less consideration was given to the potentially far-reaching impacts of government-mandated shutdowns.
“I think what people hadn’t really contemplated was what a national lockdown would mean and how devastating it would be in terms of economic impact,” Van Slooten says. “If people were openly talking about the potential for pandemics to happen, they don’t seem to have considered what the full consequences of that might be beyond mortality.”
The full impact of COVID-19 on the reinsurance market remains a question mark that could loom over the industry for years to come. In some areas, the pandemic is improving loss ratios. Automobile insurers, for example, have in some cases been able to provide refunds on premiums as driving-related exposures have declined.
Meanwhile, many businesses impacted by shutdowns have sought relief and found business interruption policies in the United States are generally written on standard forms that require direct physical damage or carry a virus exclusion clause. Still, more than a thousand legal challenges have made their way into U.S. courts seeking to force payment on those policies. So far, almost all have ended favorably for insurers, but litigation around COVID-19 coverage could drag on for the foreseeable future.
While coverage under some policies is disputed, other claims are clearly covered and will be paid as a result of COVID-19 disruptions. Some of these losses are likely to hit the reinsurance market.
“Event cancellation is a fairly highly impacted area, and that is still ongoing, but it will diminish over time because event cancellation policies that don’t have COVID-19 exclusions are going to be more rare as time goes on,” says Keith Wolfe, president of the U.S. P&C division at Swiss Re. “Credit & surety is another line of business that has been pretty materially impacted by this because there were a lot of things going on in the world that were not able to be completed because of the pandemic, whether that’s delivery of goods or services or construction projects.”
Wolfe continues: “The other area in the U.S. that we’ve seen a modest impact is workers’ compensation. That area has seen an uptick in claims related to health care workers and other essential workers who obviously are in situations where they could possibly contract the virus at work.”
In addition to claims, COVID-19 has created other headwinds for the reinsurance industry.
“You’ve had emergency cuts in interest rates to close to 0% in both the U.K. and the U.S.,” Van Slooten says. “You’ve got a lot of uncertainty around the reserving for COVID-19, what the ultimate loss burden is going to be, and how it’s going to be distributed across the industry. We think there’s going to be some additional collateral that’s trapped in the retro space, so we don’t think recession protection is going to be any easier to buy at the end of the year versus last year either. All of those things have been made worse.”
In addition, Van Slooten says there are signs of upward pressure on reinsurance pricing due to the pandemic, which represents a shift. Typically reinsurance pricing goes up in response to a shortage of capital, he says. But this is the first time the market has shown signs of hardening based on earnings.
Pricing adequacy and capacity allocation strategies were already under scrutiny prior to the pandemic, driven by shifting views and appetites about risk, reduced alternative capital inflows and higher loss cost trends, says Mowery. Those trends have been exacerbated by the pandemic.
“Reinsurers are exhibiting increased scrutiny relative to deployable capacity post-COVID-19, and at the mid-year renewals, this resulted in adjustments to programs across most lines of business,” she says. “Accounts that experienced meaningful losses within the last year or two, in particular, came under increased scrutiny. Markets nevertheless continued to meet cedents’ needs overall and were willing and able to focus on individual client needs, custom solutions and differentiated renewal strategies. For an industry founded on the principles of diversification, we are now grappling with the implications of the first globally systemic insurance loss. As a result of market volatility and uncertainty, at mid-year 2020, capacity tightened and pricing adjusted.”
Claimants seek a path forward
Whether or not COVID-19 business disruption claims could hit the reinsurance market remains to be determined. Insurers have denied most business disruption claims under commercial property policies because the losses cannot be tied to “physical loss or damage,” a provision included in most standard contracts in the United States.
More than 1,000 lawsuits have been filed against insurers since March seeking to force payment on claims related to COVID-19 business disruption. The majority of those cases have ended favorably for insurers due to the inability of plaintiffs to overcome the physical loss or damage bar as well as virus exclusions.
However, an “outlier” case has injected some uncertainty into the situation and provided a potential path forward for certain policyholders in business disruption claims. Studio 417, a Springfield, Missouri, hair salon and several restaurants sued Cincinnati Insurance Company seeking payment on a business disruption claim under all-risk policies on the grounds that COVID-19 is a physical substance that rendered their facilities unsafe and unusable. Notably, the policies in question did not include virus exclusions.
In August, the U.S. District Court for the Western District of Missouri Southern Division denied Cincinnati Insurance’s motion to dismiss the case, allowing it to proceed to discovery.
While much of the spotlight in 2020 has been on the ongoing COVID-19 crisis, other exposures continued. The fact that the alphabetical list of storm names was already exhausted by mid-October and we were already making our way through the alphabet a second time is an indication of how active the Atlantic hurricane season has been in 2020.
“While COVID-19 took center stage since about March of this year, the other challenges are not diminishing,” Freiboth says. “We are still looking at an elevated level of higher verdicts or settlements, interest rates hovering at very low levels, natural catastrophe losses in all areas of the country, from tornado, hail, hurricane or derecho losses to severe wildfires in Washington, Oregon, California and Colorado. 2020 was already to this point, still at the beginning of the fourth quarter a very busy year with plenty of loss activity.”
Although the loss events have been small to medium-sized so far this year, there’s been enough of them that it adds up to a significant impact, Wolfe says. In addition, the occurrence of unusual events could point to longer-term climate change concerns. For example, a derecho hit the Midwest in August, spawning winds up to 126 miles per hour — the equivalent of a category 4 hurricane — along with tornadoes, torrential rain and large hail that ravaged Iowa, Illinois and surrounding areas.
“This was a very material wind event that damaged buildings and destroyed crops,” Wolfe explains. “This is an event that is very likely multiple billion dollars that didn’t really hit many peoples’ radar because there was a lot of other news going on at the time. There was obviously a lot of news around the pandemic, wildfires in California were starting to burn at the same time, and there were tropical storms in the water. But, it was not a small event.”
This event and others could continue to impact pricing adjustments that have already been ongoing both in primary insurance and reinsurance markets, he says.
“We would not have seen a lot of frequent or severe wind events in the upper northwest. Now we have one,” says Wolfe. “That wasn’t really contemplated in a lot of pricing of insurance and reinsurance products. Wildfires out west have been a certainty for the last four years, and you could argue a little bit longer, but the reality is if you look at 2017 and 2018, and now 2020, these are very much worse than almost any other year we could possibly look at in history in terms of wildfire extent and damage.”
Interest rates: A new basement
All of these impacts on the risk side are happening at a time when interest rates remain low. Any hope the industry had at the beginning of the year regarding interest rates potentially starting to come up were dashed when COVID-19 emerged.
“We thought interest rates were already at rock bottom going into 2020, and we were proven wrong quite clearly through the year,” Wolfe says. “We were seeing stress already in the underlying results once you contemplate asset returns, as well as discount rates on long-tail liabilities and that pressure, just became considerably greater through 2020 — more than we would have anticipated.”
Low interest rates are impacting both the primary and reinsurance markets, and the only way to address that pressure is through rates, he says.
“I would have told you pre-COVID every line in the United States was seeing some sort of increase in rate to account for these drivers. Workers’ compensation would have been the exception, and now I think with COVID having a small uptick in loss costs in workers’ comp, I’d expect workers’ comp will not see deteriorating rate going forward for the next 12 months.”
With interest rates in the basement, ratings agencies have been warning about reinsurers’ ability — or potential inability — to meet their cost of capital hurdles. Indeed, Fitch Ratings predicted in May that the global reinsurance sector would fail to earn its cost of capital in 2020 amid the coronavirus crisis and took negative rating actions on six of 22 reinsurance groups reviewed. In September, Moody’s changed its outlook for the global reinsurance sector to negative from stable, citing a challenging operating environment as the pandemic weakened profitability.
“Uncertainty around ultimate coronavirus-related losses, along with low interest rates, shrinking reserve releases and more expensive retrocessional coverage will all be a drag on reinsurers’ profitability in the next 12 to 18 months, despite stronger reinsurance pricing,” says James Eck, vice president and senior credit officer at Moody’s. “Coronavirus-related losses and other catastrophe events have already depleted the annual catastrophe-loss budgets of many firms.”
Mowery estimated companies will need to maintain combined ratios in the low 90s going forward to account for a decline in reserve releases and investment income.
“Rating agencies continue to expect companies to hold significant excess capital in the face of macro-level uncertainties,” she says. “In response to these challenges, pricing is impacted and capacity is being allocated more carefully.”
The market will likely remain challenging for the near term, with low interest rates, uncertainty about the long-term impacts of COVID-19, and the possibility of another active catastrophe year in 2021 impacting the market. Meanwhile, new risks are emerging around environmental, social and corporate governance (ESG); civil unrest; climate change; and new technologies, including satellite imagery, sensor technology, smart homes and autonomous vehicles.
Policy language is likely to be examined and terms and conditions tightened to clearly define the scope of coverage or exclusion for pandemic events and other exposures.
“For the upcoming renewals, the expectation is that pricing will have to increase significantly especially for loss-impacted business,” Freiboth says. “We will have to be clear on insurance and reinsurance coverage provided, especially with respect to pandemic coverage and non-affirmative cyber exposure. Collectively, we will have to work on risk aggregations for certain exposures through underwriting measures and with the help of technology.”
In addition, there is a groundswell of support among insurers and reinsurers for public-private partnerships (PPP) to shoulder the burden of risk in the event of massive events like COVID-19.
“There are various PPP schemes being talked about, but the basic principle is that the insurance industry can bring expertise and risk management as well as potential risk transfer to the market in the case of large-scale events like the pandemic, but insurance isn’t designed to cover events of this scale,” Van Slooten says. “It’s quite clear that the insurance industry is not set up to effectively cover the cost of closing a national economy. Ultimately you need the government to act as a backstop.”
And amid the overhang of a global pandemic and its potential long-term implications on the reinsurance industry, other risks continue to emerge, but experts unsurprisingly note that with risk comes opportunity for the industry.
“The broad range of emerging risks, importantly, will lead to new opportunities,” says Mowery. “As an example, as big data becomes more critical and pervasive within virtually all aspects of the insurance industry, it introduces risk of algorithmic or data bias. Methods for identifying, mitigating and protecting against unintended outcomes will grow in importance. The reinsurance sector has a strong track record of responding to periods of change. Putting capital to work to create new coverages and meet evolving demands will be crucial in securing the sector’s long-term relevance.”