The threats that face both non-life and life insurers are wide-ranging, so companies must watch developments very closely with regard to rates, terms and conditions, and capacity to underwrite business, says AM Best.
The global ratings agency adds that although some risks do not surface in management teams’ day-to-day processes, they cannot be ignored, despite their remote probability.
A just-published report from the agency, entitled ‘The ‘Grey’ Swans: Top 10 Threats to European Insurers’ Financial Strength’, identifies the biggest risks to the credit quality and financial strength of insurers. AM Best describes grey swans as known risks that are low-probability high-severity events with the potential to impair an insurer, and include mega catastrophe events, financial system shock, risk management shortfall and hyperinflation.
The report discusses how AM Best’s analysts assess insurers’ management of these complex challenges. The agency “expects highly rated insurance companies to consider the grey swan risks and take steps to guard their balance sheets against such tail events.”
The ‘top 10’ identified by the report – and the agency’s comments – are as follows:
- Mega Catastrophic Event: A single extremely large loss – on the scale of US$100bn or larger – stemming from a terrorist event, pandemic or natural disaster such as a severe hurricane or earthquake could impair the balance sheets of a number of insurers. Coping with these extreme events would require the combined efforts of governments, insurers and citizens. A catastrophe loss at an extreme level of severity, for example, a USD 250 billion single-hurricane insured loss event hitting Southern Florida, could put even a well-capitalised company out of business.
- Financial System Shock: The 2008-2009 global financial crises represented severe, live investment stress tests. In fact, the evolution of the reverse stress tests was a result of the financial crisis. While no one can predict with certainty where and when the next financial crisis will occur, it is important that companies prepare for future shocks in the financial markets and maintain a strong capital buffer and access to liquidity. A protracted low interest rate environment can also pose a significant threat to life insurers’ business models, especially as tight spreads reduce investment income and crimp product margins.
- Risk Management Shortfall: A mismatch between risk appetite and risk management capability represents another condition that can lead to threats against credit quality and financial strength, as new sources of business are sought and greater risk is assumed to preserve or grow top lines such as increasing activity in developing markets, extending cover for terrorism or cyber crime.
- Hyperinflation: Hyperinflation is yet another grey swan that is of concern to insurers. A spike or a too-rapid increase in interest rates would typically signal higher inflation and could leave insurers challenged to reflect rising loss costs in pricing and to keep pace in reserving. Though hyperinflation is difficult to predict, even a modest unanticipated rise in inflation can create a great deal of economic uncertainty; affect claim costs, loss reserves and asset portfolios; and pose a big risk to insurers. This is especially true for life insurers, which could find it difficult to sell life savings products in a high-inflation/high interest rate environment.
- Model Error: The insurance industry has developed complex modelling and analysis techniques, but overreliance on models and an unfailing belief in their accuracy could lead to a false sense of precision. Without the knowledge of model limitations and the causes of model failure, deficiencies in data quality and computing capability, among other factors, could play a role in insurers underestimating potential maximum losses (PMLs), thereby causing catastrophic events to blow through the top end of reinsurance protection. In addition, just because two events are not statistically ‘correlated’ does not mean they cannot happen at the same time, such as both a catastrophe loss and a market crash or some other liquidity event.
- Regulation: More stringent regulatory oversight and governance requirements have taken hold since the financial crisis. Changes associated with insurance industry regulation, which are increasing worldwide, are viewed as challenges by many insurers in terms of capital adequacy, risk management and reporting requirements, which could affect insurers’ business models, capital levels, operating processes and product offerings.
- Alternative Capital: An influx of pension funds, hedge funds, private equity firms and endowment capital are now competing with traditional reinsurers for catastrophe risks, profoundly altering the landscape of the insurance and reinsurance markets. While the involvement of alternative capital creates some positive incentives for the industry, the overriding threat is that the capital markets’ hunger for insurance risk could create a permanent soft cycle in which traditional reinsurance players run the risk of becoming disintermediated. For catastrophe reinsurance, low barriers to entry and competition from alternative capital are putting pressure on profit margins and could have negative implications on ratings for the reinsurance sector as a whole.
- Emerging Underwriting Risk: Emerging underwriting risks, for example, asbestosis and environmental claims in the US that originated decades ago and are still being litigated, are difficult to anticipate but could have a major impact on insurer financial strength. They might include cyber risk, terrorism, food security or space weather, as well as risks associated with changing demographics. All involve a high degree of uncertainty. Developing risks by their nature are difficult to identify especially when the landscape is rapidly changing, and risks that are hard to identify can easily be underpriced. The common denominator among these risks is that if underestimated or not hedged via contract wording, exclusions or sub limits, they represent a high potential for losses, creating a challenge for underwriters.
- Interest Rate Spike: Insurers realise they must consider the continued low rate environment and make business decisions that reflect low fixed-income returns. Though gradually rising interest rates would benefit insurers over the medium and long term, a sudden spike in rates would be a serious concern, since fixed-income instruments make up the greater part of insurers’ investment portfolios. Since yield spreads and bond prices move in opposite directions, sharply rising rates would cause unrealised gains accumulated during years of a low rate environment to suddenly reverse and become unrealised losses. A rapid spike could give policyholders the incentive to cancel their life savings and annuity policies and jump ship to higher return savings products.
- Loss of Talent/Entrepreneurial Spirit: Among the greatest risks to the insurance industry is the loss of talent and entrepreneurial spirit. Attracting newly qualified, highly skilled talent is essential to the industry’s future. As a result, the industry must play a stronger role in attracting younger workers and highlighting interesting career options within the insurance sector. It is essential for insurance companies to be viewed as dynamic employers that attract and retain the best and brightest.
The full report, which offers solutions to the risks identified, can be accessed here.