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The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance

The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance

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The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance explores the challenges presented by today's business and economic upheaval, as well as the hardening insurance market, and what it means for the captive insurance industry.

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5 Reasons We May Never See Another Hard Insurance Market

Magnifying Money Graph
May 02, 2018

At a recent captive insurance board meeting, Editor John Foehl happened to sit next to a reinsurance broker for one of the major brokerages at dinner. As is typical in situations like this, they talked shop. Mr. Foehl inquired how July 1 renewals were shaping up from a pricing perspective. The broker indicated that, especially for property coverage, prices were either stable or down slightly. This after a year where the Insurance Information Institute estimated global insured catastrophe losses at $135 billion or 3 times larger than the average for the past 10 years. The conversation reminded Mr. Foehl of a blog post by James Twining, CEO of Kingsbridge Group in London, titled "Five Reasons We May Never See Another Hard Market."

Last May, we wrote about the need for captives to remain vigilant in navigating the soft market conditions. And while we didn't necessarily suggest an end to hard markets, we commented that captives needed to provide more additional services and features to members than commercial insurers do. Now comes the article from James Twining. For captive insurers, the question is, if his thesis is correct, how do captives adapt? With Mr. Twining's permission, we have reprinted the entire blog post below. If nothing else, it should provide some intellectual stimulus for ongoing discussions at captive board meetings.

5 Reasons We May Never See Another Hard Market

"Never," as Peter Pan reminds us, "is an awfully long time."

Even so, an entire generation of people operating in the insurance market today has never seen a hard market—the last one, in case you blinked and missed it, was triggered by 9/11, before running out of steam a few years later. And since then, five fundamental changes to the way the market operates have potentially raised the very real prospect that many of us will never see another traditional hard market in the course of our working lifetimes.

What's changed?

Well at one level, nothing. The market is still made up of capital. To the extent that there is an oversupply of capital versus actual and expected losses, then insurance and reinsurance prices come under pressure, coverage terms get relaxed, and insurers bite big chunks out of each other. To the extent there is a capital shortfall, then prices firm up, underwriting terms tighten, and competitive pressures ease. In this respect, the insurance industry continues to operate as it has done for over 300 years.

Within this context, prices are clearly currently being weighed down by a number of short-term factors. 

For example, while Lloyd's may have had a somewhat bumpy 2016, the overall market continues to enjoy one of the most benign loss periods in recent memory, which is artificially inflating the industry's profits and attracting a certain amount of "naïve" capital into the market. History and common sense tell you that this cannot go on forever. Hurricanes Harvey and Irma are proving that.

Interest rates, too, continue to bump along at historically low levels—in fact, in the United Kingdom, they remain stubbornly fixed at the lowest level since records began in 1694. That, too, surely cannot last forever, although a combination of factors means that it could be years until they start to move.

And short-term competitive forces have led many insurers—whatever they may say—to write policies at prices and on terms that they would never have previously countenanced, just to retain market share, and release reserves to bridge the gap. That is surely also unsustainable.

That is not to say that there aren't some isolated factors pulling in the other direction, too, particularly in personal lines markets. Try telling the average UK motorist that rates are soft, for example! Increases in insurance premium tax and cuts to the Ogden discount rate (used to calculate personal injury payouts) have increased the average car policy by around a third in the last 2 years. Medical markets continue to experience strong underlying growth dynamics, driven by the impact of claims inflation. Cyber also shows positive pricing characteristics as people grapple with an entirely new risk class.

However, beyond these short-term factors, there have been five fundamental changes to the way the market is structured and operates that are driving a long-term impact on the traditional rating cycle.

1. Alternative capital is driving long-term structural overcapacity.

Alternative investors, primarily made up of hedge and pension funds, have been increasingly attracted into the market by its sustained ability to deliver returns in today's low-interest environment. The result has been a flood of new capacity, primarily targeted at the North American catastrophe reinsurance market in the form of cat bonds, insurance-linked securities (ILSs), and sidecars, but increasingly exploring casualty and international risks. ILSs, for example, now represent 18 percent of the global reinsurance market.

The returns that these new investors are willing to accept are significantly lower than the market has historically priced in. The average return on capital for those playing in these markets is said to have fallen from 14–16 percent to 6–8 percent over the last few years. The fall in reinsurance prices has fed through into falling primary insurance prices as competitive forces have, by and large, led to insurers passing on any savings to their clients.

While some have speculated that a return of "normal" interest rates or a major loss event (let's see what the final bill for Irma turns out to be) would cause much of this new capital to disappear, the market consensus is that most of this capacity "overhang" will remain, as most new investors in the class see insurance as a source of alpha and a central part of a diversified portfolio strategy. Moody's and Fitch are both seeing further reinsurance price reductions through 2017/2018.

2. Data and analytics are driving enhanced underwriting and risk retention.

According to IBM, 90 percent of all the data in the world has been created in the last 2 years. This "explosion" of data, driven largely by the advent of smartphones and other connected devices (i.e., the so-called Internet of Things), has coincided with dramatic advances in computing power and data storage and equally marked reductions in the cost of this technology thanks to cloud-based networks and other advances. As an example, the first human genome took 13 years to sequence. Researchers can now do this in an hour.

These advances in data availability and computing power are driving advanced analytics and artificial intelligence/machine learning on a scale and at a pace never before possible. The potential implications for the insurance industry—which arguably is an industry built around the flow of money (premium/claims) and the flow of data (underwriting)—are hugely significant in terms of the accuracy with which individual risks can be underwritten and priced and the efficiency with which claims are managed.

While, theoretically, greater efficiency could be captured in the form of improved returns for insurers, the proven reality of the market's competitive dynamics means that savings will largely be passed on to customers in the form of price reductions, largely negating the impact of any cyclical price increases. Given the market's current inefficiency, this could take years to play out.

Improved analytics are also driving a growing trend toward greater levels of risk retention by larger corporations via captives and other structures and by insurers themselves in terms of their reinsurance requirements. McKinsey, for example, estimates that, on average, over 35 percent of risks are now retained by large corporations, up from 30 percent in 2010. This is taking premium out of the market, creating further excess capital.

3. Improved risk prevention is reducing demand.

Improvements in risk engineering techniques and capabilities combined with the increasing sophistication and prevalence of sensor-based technology (e.g., GE estimates that the sensors in each of its jet engines now create 1 terabyte of data per flight) are helping organizations both improve how they identify and preempt potential risks and react faster to events when they occur.

Over time, this will lead to less risk needing to be placed into the primary and reinsurance markets.

4. Emergence of regional capital hubs is enabling cheaper local underwriting.

The steady growth of regional capital hubs such as Singapore, Dubai, and Miami is leading to more risk being placed locally at cheaper prices, rather than being placed in the traditional markets of London, Bermuda, and New York. In Miami, for example, over 40 insurers have established operations over the past few years to serve the Latin American market.

While it could be argued that a lack of expertise and experience is causing some of these local insurers simply to misprice risk, this ignores the fact that the cost structure of the traditional markets is bloated by huge frictional costs because of the inefficiency with which business is placed, not to mention significant regulatory costs. Further, local markets are gaining sophistication and depth all the time—risks are now placed directly into Singapore that only a few years ago would have had to travel to London.

It is often simply cheaper to write business in these emerging local hubs, again reducing the amount of premium in the market. The question may be to what extent this is offset by growing local demand for coverage as population numbers, gross domestic product per capita, and insurance penetration increase?

5. Efficiency of capital deployment is eroding market hardening at source.

One of the consequences of the relentless march of globalization over the past 30 years has been the greater mobility, flexibility, and fungibility of money.

Previously, when there was an event in one part of the world or prices started to harden in a particular line of business, the inefficiency in capital flows caused prices to fluctuate significantly and raised prices. The development of much of the Bermuda market can be traced back to a desire to exploit just this phenomenon, with capital sitting there ready to be deployed when the market turned.

Now, capital providers are able to immediately deploy capital anywhere in the world to exploit emerging pricing opportunities. As an example, in 2014, aviation rates hardened following a series of terrible crashes (an Air Asia and two Malaysia Airways flights being the most high profile). Airlines renewing at that time faced the first price hike they had seen in years. However, within a few months, pricing was back below its previous level. Further, those who had renewed during that small window of time found that their brokers were able to renegotiate their deals at the lower rate with no loss of coverage. What this means in concrete terms is that any sign of a recovery in pricing is far more prone to be strangled at birth.

The implication of these five long-term structural changes is clear. While the underlying cyclical nature of the industry has clearly not changed—or we would not be seeing continued price declines!—the cycle will lengthen and flatten. In other words, the distance between peak and trough will be far narrower than in the past, the time intervals between each peak much longer, and the speed with which prices readjust back down following a huge event (or series of large events) much faster.

This potentially marks a seismic shift in how people in the market need to think and operate, which will in turn drive the following.

  • Further consolidation within both brokers and insurance/reinsurers as scale, efficiency, and portfolio diversification become ever more critical factors in driving earnings growth

  • Disruption along the value chain as players seek to maximize the value of their books and secure distribution efficiencies

  • Significant investment by players into efficiency measures, spanning restructuring and information technology/automation (i.e., robotics). McKinsey has estimated, for example, that technology can reduce insurers' combined ratio by 15–20 percent, and, according to Celent, 50 percent of European insurers are said to be planning to replace their core insurance systems.

  • Investment into insurtech incubators and venture funds

For the record, I would be inherently skeptical of any investment thesis built around the hope of a hardening market, with the margin for error in a buy low/sell high strategy now vanishingly small. And anyone hoping that Hurricanes Harvey and Irma will tip the balance is likely to be disappointed, with Morgan Stanley arguing that their combined impact is likely to be an earnings event for the industry as opposed to a capital one—such is the extent of the sector's overcapitalization.

Time, which as Peter Pan tells us is like the ticking crocodile, "chasing after all of us," will I guess tell whether the traditional insurance cycle paradigm is truly dead. I wouldn't hold your breath.

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