- The Short Term
- The Long term
- Summary: A Market Solution
The current coronavirus pandemic, otherwise known as Covid-19, is already being described as the biggest single issue faced by the world since World War 2, and without doubt it will be one of the biggest issues faced by the insurance industry ever. However, there have been plenty of other large issues in relatively recent history, including natural catastrophes such as cyclones and hurricanes, earthquakes and tsunamis, floods and fires, and man-made losses such as oil rig collapses, the World Trade Centre and other terrorist activity, and the Global Financial Crisis.
One of these events, perhaps a little in the past now, was the making of the industry with the use of three simple words: “pay all claims”; while others have been more existential, claiming the scalps of several insurers.
This article, co-authored by a small team of ICSR experts in the fields of Governance, Compliance, Claims, Risk, and Operations, aims to look at some of the activity which is or should be taking place now; the short, as well as some of the possible longer term consequences, with a view to providing some guidance for insurers and brokers on what to do and what to look out for in the future.
The Short Term
The coronavirus has now spread to every continent other than Antarctica. Hundreds of thousands of individuals daily are becoming very unwell, and hundreds of thousands have died with some countries still at the early stages of the spread of the virus. Businesses have had to cease trading temporarily, and in some cases potentially permanently, while many employees are being furloughed and others are having their employment terminated. Travel, both locally and internationally, has been severely disrupted.
In a significant number of cases there is no insurance to protect individuals or their businesses, while for others insurance cover may be available and potentially generating considerable claims under their policies (for example in the case of contingency cover and income protection). There remains the potential for some insurers to be forced to pay in circumstances where cover was not afforded, or to pay claims for which they did not believe they had provided cover.
The one certainty at this point is that there is uncertainty, though perhaps one other certainty also exists: there will be many claims and complaints made, and a great deal of litigation and media scrutiny. Some of the uncertainty relates to unclear policy wordings, or because the event itself was not anticipated. That is, however, the rationale for insurance, and companies are expected by their clients to be prepared for events such as this one.
So now, during and after the event, insurers and brokers need to do more preparation than ever. Insurers need to prepare for claims, complaints and litigation, but also to understand the potential scale and cost of the problem in front of them to determine both their strategy for future dealings with their clients as well as, more existentially, their capital position.
The first step for insurers and brokers is to identify which policies may respond for their customers and to categorise them, as follows:
- Those policies where any losses are clearly excluded,
- Those policies where cover may or may not be excluded (including, but not limited to, policies where a government may require compulsory cover regardless of the wording),
- Those policies where cover is afforded.
The policies which are likely to require this assessment will include life, travel and income or loan protection policies for individuals and business interruption cover for businesses. There may be others, but these are certainly the key ones under consideration at the present time.
More generally brokers will need to determine which of their clients may be impacted, while insurers will have to calculate both the possible and probable maximum losses in the near future, before any applicable reinsurance. This work will have already commenced and many firms in the Lloyd’s environment are under pressure to produce estimates, but uncertainty will arise in determining the length of the pandemic, making any calculation of the current levels of capital required unreliable, and in turn making any determination on the adequacy of existing capital individually and across the market extremely difficult.
Insurers and reinsurers will also need to look at existing (and future) reinsurance arrangements going forward, to determine what reinsurance cover will be available now, or not and what should be in the future.
Where an insurance policy or a reinsurance policy falls into the “unknown” category, firms will need legal advice on the terms and conditions of cover to identify the strengths and weaknesses of any arguments, to determine across the board where cover is likely to be afforded or not.
Insurers have already received many speculative claims and are currently seeking this advice. This process should be not rushed but equally undue delay is not going to be helpful to businesses close to going out of business. Many law firms will need to be careful during any conflict search. It is likely that insurer affiliations will obtain advice on behalf of their members, while some, such as the LMA, have already issued tighter wordings to bring certainty to any future pandemics for their customers.
We note that it is simple enough to suggest what is required going forward as an outsider, but far less so while inside a firm under stress to produce the information under tight time constraints, and even more so when employees are ill and/or working remotely. Senior management will be extremely keen to understand the financial security of their firm and deliver a strategy for claims under demands from brokers and clients, while the regulators will also be keen to see that firms and the financial system as a whole is secure and that firms are treating customers fairly and continuing to provide an appropriate level of service to their customers.
The Long Term
The following are some of the issues we believe will have an impact in the longer term on individual firms and the insurance market as a whole.
Risk Management is all about the identification, assessment and mitigation of risk. No one will now argue that they could not have seen some type of event of this nature occurring, but there is little doubt that some firms failed to identify the risk, and more will have failed to have properly assessed it.
However, we are not going to lay fault at the feet of risk managers: only in February Whitehall and their scientific advisors voted to keep the risk to the UK of Coronavirus at moderate, despite the serious statistics already coming out of China and Italy.
At that stage some international risk experts still placed regulatory intervention as a higher risk to financial services firms than pandemic.
Undoubtedly an element of human bias was at play. It was in plain sight, but many did not see it or judged the risk to be far too remote for their risk registers. The size of the potential impact may also have played a part with even catastrophe exposed insurers unused to thinking of events of this magnitude as a true risk rather than something which may emerge.
There is little doubt that risk management will be placed under the microscope, both by firms themselves and by their regulators. These reviews will be wide-ranging, including a consideration of how embedded the risk management function is within an operation, and how wide ranging are its activities, all the way up to a consideration of whether this scale of event can even be insured within the current market format on a risk by risk basis.
Firms have largely done well on business continuity planning for remote working, and business is continuing. But having the ability to log on remotely does not mean that working practices have been efficient and effective, or that employee wellbeing is currently managed appropriately. There is much anecdotal evidence that managers are spending substantially more time managing than they usually would: as a result productivity is being impacted and stress levels are high, not least because in many cases employees are having to be teachers as well as parents, and possibly looking after their aged parents while also concerned for their own family’s wellbeing.
However business continuity has been achieved, it does not lead to the conclusion that risk management has been fully embedded within all insurance businesses, on either the Business Continuity Planning or indeed the risk side. We have seen many insurance policies likely to fall into the uncertain cover category: the potential impact of a pandemic is extremely large, even if until recently the possibility was considered quite remote, and there are too many firms with policies which may provide unintended cover for this type of event.
A comparison to the market response on Cyber as a risk to an insurer or broker’s business may be pertinent. The risk was not considered to be as remote and consequently more was done within the industry to respond to the potential risk with firms taking steps to protect their IT from hacking, but to also identify possible sources of cyber risk and to develop specific cover. Insurers and brokers also worked to identify where cover may have been unintentionally provided and resolve uncertainty in policies.
Our ICSR Talent Pool member David Russell, has already published an article on questions which Boards of Directors and in particular NEDS should be considering at this point in time which can be found here. (Pandemics and the Board: From adversity comes opportunity)
In the longer term and with the expected regulatory diagnostic work to come on what went wrong, we might expect one of the issues to be considered will be the membership of Boards and their constitution. Can they impose an obligation that risk and operations be at the heart of Governance, and is it perhaps already there for firms subject to Solvency II but failed? Are there too many Boards which remain heavily dominated by those from an underwriting or broking background? Do NEDs, currently not necessarily the subject of SM&CR, need to be more generally skilled? Should NEDs need to evidence experience in risk and/or operations, particularly with Operational Resilience coming down the line soon?
How will the regulators otherwise ensure that issues considered matters of “hygiene” by some such as Operations, Risk and Compliance are elevated? SM&CR Senior Management Function (SMF) role apportionment for these at a broader range of firms and as board level Functions seems an obvious choice. Perhaps we will see changes to the current approach on Operational Resilience or perhaps some changes to requirements for Board membership.
Whatever does come down the chute, we can be sure of one thing. There will be a focus on governance and we can expect some changes.
Product Governance and Underwriting
An area which will also be looked at more closely will be a firm’s response to the Insurance Distribution Directive (IDD), and the FCA’s product governance requirements. Many firms have taken the view that this is primarily a requirement for consumer and SME business, as their customers are at highest risk of harm, and have therefore developed processes in line with risk appetites around these risks.
The market as a whole took this general approach because PROD states: “Good product governance should result in products that:
-meet the needs of one or more identifiable target markets;
-are sold to clients in the target markets by appropriate distribution channels; and
-deliver appropriate client outcomes.
There is no mention here of the importance of ensuring that the product is designed to be within the risk appetite of the firm and should respond accordingly. Consequently, product governance processes within firms may match regulatory expectations but may not necessarily include any element of design to ensure that the firm’s risk profile is unaffected.
Product governance itself is good practice. If undertaken with a slightly different approach, in our view taking a more holistic approach rather that considering them on a product by product basis as a process and only seeking to meet regulatory expectations, it should ensure that product development is structured and integrates good risk management.
If all the products now in play for potential claims had been subject to a detailed and holistic product approval process, and took account of risk management assessment of the risks to the business as well as (at a regulator level) more generally to the London Market and internationally, we may have seen a response to pandemic risk more in line with its response to cyber, and at least some of the insurers would not now be concerned about the potential claims under their policies, or indeed to the existential threat to their businesses.
It is a lesson well learned, and one which we hope will lead to a change in dynamic for the development of new products and the regular review of those already being distributed. It is also a lesson which may be imposed upon businesses who do not learn from it, as regulators get to grips with the potential industry wide threats that may arise in the future. In this regard, we have now seen the new FCA Business Plan for 2020/21 and it is a clear that a new approach is coming focused on the outcomes not the rules. One area likely to be central to that is Product Governance. Firms may have met the rule requirements but the significant number of claims being made which are being rejected suggests that the approach has been too ‘tick box’ and not enough outcome based.
It remains to be seen what the ultimate impact of the current circumstances will be for insurers, and what impact they may have on their capital. However, there is considerable concern in the market at present that firms will find themselves to be the subject of significant claims and consequently under-capitalised, which is, of course, very different to the question of whether they are solvent.
Calculation of capital for insurers under Solvency II is a complicated process. For insurers with internal models that includes a significant and thorough assessment of that model and oversight of all of the parameters set during the calculation process. The firm itself has to have a detailed process for that oversight and will be subject possibly to third-party review and regulatory input. An element of that is the risk assessment for the firm and the output of that risk assessment.
Solvency II was designed to ensure that a firm’s balance sheets are strong and enough capital is held. It is a part of the approach to ensuring the strength of the financial markets as a whole. Another element, following the Global Financial Crisis, was to ensure that infrastructure was not completely inter-dependent, that there were no inherent systemic issues or faults, and that they were mitigated as much as possible.
Despite this, what we now see is a market where almost all firms have under-played the likelihood and impact of a significant risk. Human bias, or behavioural economics, appear to have played a role, and it is interesting that not only have the firms and their advisors been subject to this bias but so too have the governments and regulators, with the latter category having been engaged closely in the development and review of the capital models of firms.
Because of the importance of insurers maintaining solvency and appropriate capital for the market to function as a whole, we should expect to see a focus on capital models by regulators as a part of their “what went wrong (and what worked)” analysis in due course. In fact, the regulators have already agreed to a delay in the delivery of Solvency Returns for insurers who provide returns identifying the impact of the Covid-19 crisis on their capital position. This can be seen as both a wish to get assurance from individual firms about their solvency, and also the first step in a process of reviewing the Solvency II capital calculation process and models.
The market is well aware that “the next big thing” in regulatory terms has been billed as the work which firms will need to undertake on Operational Resilience. The change in philosophy required is to recognise that insurers (and other financial institutions) need to treat the operational aspects of their business as a key part of the services which they provide to their customers, by bringing the back office into the saleroom to be treated with an equal degree of investment and oversight: insurers are selling a service to their customers, and all aspects of that service must be resilient.
Operational Resilience has historically been seen as primarily related to IT resilience, out of the concern that a cyber-attack or other insurer IT failure (a poor migration, for example) could have a significant impact on the ability of an insurer or broker to provide a continuing service to customers in need and at risk of harm should that service fail.
Operational Resilience includes all key elements of the delivery of service to customers, including the ability of firms to continue to provide that service under any circumstances, including, as now seen, a pandemic. Presently at a consultation stage now elongated by the current crisis, we can expect a response early in 2021, which is likely to be in the form of a Policy Statement, with or without guidance. It may also include new regulations, although this may not be necessary given the existing framework.
The regulators are already following the actions of insurers and enquiring about their approach and the effectiveness of their continuity plans once implemented. This process will lead to lessons for them, and ultimately to how they view a firm’s responses to the requirements as laid down by the PRA, FCA and the Bank of England. It will also, however, provide considerable guidance to them as to whether the consultation process has gone far enough.
Recovery and Resolution Planning
Many firms in recent years have been required to prepare Recovery and Resolution Plans. For the larger firms it is a requirement, while for others it has been a polite request in the firm’s PSM letter. Those plans are designed to kick in when a firm is facing financial difficulties of one nature or another. Generally, they are carefully drafted to be aligned to the firm’s capital requirements and the firm’s monitoring of its capital and risks. It will usually also be aligned with the PRA’s Proactive Intervention Framework, although in the case of Lloyd’s, the capital arrangements require a different approach, mostly where third-party capital is involved.
Often the most significant risks are considered in the Plan as examples of what might happen, and the response required in the form of a high-level plan of action. None of the Recovery and Resolution Plans we have seen in our work included a response to a pandemic. This is primarily because the frequency and likelihood, was considered too remote, a “tail” risk. As firms review their risk registers and make appropriate alterations to their ORSAs, and possibly their capital calculations consequent upon current circumstances, it will be necessary to review the Recovery and Resolution Plan as well.
Firms have already started to consider the longer-term outcome of the pandemic and are battening down the hatches. The financial outcome is uncertain, a bleak word but often used at the moment. The governments are taking steps to ensure balance sheets remain strong, with some larger banks withholding declared dividend payments, and insurers being asked to do the same.
It’s possible to foresee at least a similar, if not decidedly worse, economic climate for the following few years, at least with many investment advisors and economists already noting that there will likely be a U-bend on this recovery, not a deep V as initially hoped.
With that we will see the market pushed back to plan B. Prices may remain deflated, as customers can’t afford anything else, and we will see a rise in fraudulent claims as businesses get close to the brink, while firms look to see where they can be more efficient. This is likely to lead to reviews of Operating Models, integrations of acquired but unmerged businesses for efficiency and increased implementation of new technology and processes.
Pricing models will undoubtedly be reviewed, along with a further review of wordings and coverage to align more closely with a firm’s risk appetite. Brokers will be asked by their customers for, and subsequently demanding of insurers, some form of pandemic cover, which will lead to many serious negotiations across the market as renewals are impacted. In times of few and larger broking houses, these negotiations may be existential for some insurers, and it remains to be seen how strongly they pull together to speak with one voice in these discussions.
Summary: A Market Solution
Pandemics can no longer be considered a tail risk which requires little preparation. Pandemics lead to the potential for extraordinary losses, and if they are not insured then a criticism of the insurance industry will follow, which is not good for individual insurers or the industry as a whole.
A wholesale exclusion of losses arising from a pandemic is unlikely to be the answer for the industry, its customers or the financial markets themselves, and could lead to a change in regulation in some countries with the possible introduction of a compulsory cover, which in effect is what some countries are already seeking retrospectively to introduce. It remains to be seen whether this would be forced upon individual insurers, who will then need to review their risk appetite and may lead to some carriers abandoning lines of business they have insured for many years, or alternately whether some form of entity is formed to carry this risk on behalf of the market, such as Pool Re for terrorism.
The purpose of the insurance industry is to assist businesses and individuals to be prepared for a rainy day by protecting them from unforeseen events which could cause them material financial or other loss. It is also an element in the foundation of the financial system to ensure the security and continuity of the financial system on which the world is based.
A wholesale approach might result in losses from a pandemic being excluded from cover by insurers, which removes the safety net for individuals and businesses, and the safety valve for the financial system. It could also lead to significant issues with the Competition Authorities, a matter of which most market associations are all too well aware after WTC.
Discussions are already underway at the highest levels within the insurance and broking communities, along with their representative bodies and regulators. Without doubt the issue of pandemic coverage has been put front and centre in a market which has, until now, preferred to ignore an issue which is now presenting it with such extreme issues.
Whatever arises from these discussions, there is little doubt that it will fundamentally change the insurance industry over the years to come.
This report has been written collaboratively by ICSR Director Kenneth Underhill, with support from members of the Talent Pool. If you have any questions about the issues raised, please contact Kenneth Underhill in the first instance.