The COVID Catastrophe
The global pandemic is on track to be the costliest event in insurance history. It’s also a defining moment for the industry. Special Risk Section sponsored by Lexington Insurance.
The Catastrophe Special Section is sponsored by Lexington Insurance. Click on the microphone icon to listen to the Lexington Insurance podcast.
- Making History: The COVID-19 outbreak could dwarf other catastrophe losses insurers have seen.
- Solid Ground: Even with the economic downturn, the insurance industry, on the whole, is in a strong capital position.
- Rise and Shine: Innovations in products and processes are expected to emerge from this catastrophe.
Pandemic topped the list of “most extreme risks” in a 2013 Towers Watson survey of insurance executives.
It never made the rankings again.
Since then, cyberattacks have taken the lead as the most dangerous risk. But as the first five months of 2020 have proven, a computer virus has nothing on a real one.
COVID-19 is like a hurricane that doesn't pass, a wildfire with no boundaries and a cyberattack that shuts down commerce. All at once. Crossing the globe. Hitting the life, health, property, casualty and reinsurance sectors.
It's hard to quantify the full financial impact COVID-19 will have on the industry. But one thing is certain: This pandemic is on track to become the largest event in insurance history.
“It is truly a catastrophic event the proportion of which we have not seen before,” Stefan Holzberger, chief rating officer for AM Best, said. “The breadth and depth of the event, how it is affecting multiple geographies and multiple segments of the insurance market—this is really something that dwarfs the other major events in recent history.
“9/11, Katrina, going back a little further, Hurricane Andrew—those are the big events that have shaped the industry. This will be another one.”
Robert Muir-Wood, the chief risk officer at modeling firm RMS, called COVID-19 “the biggest catastrophe we've seen in our lifetime.” And John Head, the president of national brokerage for Risk Placement Services, said, “historic is absolutely the word I would use.”
There is no shortage of superlatives to describe the widespread loss and economic devastation caused by the COVID-19 catastrophe. As of early May, the pandemic had touched 215 countries, taken more than a quarter-million lives, and caused a global recession.
“This was totally unanticipated,” said Bob Hartwig, director of the Risk and Uncertainty Management Center at the University of South Carolina's Darla Moore School of Business. “The COVID-19 issue literally came upon the world this year. There was no opportunity to react.”
And yet, the insurance industry has been prepared to handle this event.
Insurers anticipate the worst and reassess after each significant event, learning from their experiences. They added virus exclusions in response to the 2003 severe acute respiratory syndrome (SARS) outbreak. They adjusted financial strategies after the 2008-09 financial crisis.
They may not have prepared specifically for a global pandemic, but their actions have left them well-positioned to absorb these losses on top of an economic downturn.
“There are funds available to pay the claims, even with the unrealized losses across multiple asset classes and the potential for further financial market volatility,” Holzberger said. “The vast majority of companies in the U.S. are well-positioned to ride out this period of volatility.”
There is a caveat to this, however. The industry's ability to absorb the impact of COVID-19 hinges on business interruption. As of early May, seven states had introduced legislation requiring insurers to provide retroactive business interruption coverage, in some cases regardless of whether policies included a virus exclusion, as most do.
If forced to pay retroactive BI, the insurance industry could be facing losses of $150 billion to $200 billion per month, according to the Best's Commentary, Legislation to Nullify BI Exclusions Poses Existential Threat to P/C Insurers. The Insurance Information Institute's estimates are even higher. The III forecast costs of up to $380 billion per month, which it said would “break” the insurance industry within months. That scenario, however, is unlikely (see sidebar page 54).
If you take business interruption out of the equation, the industry as a whole is on solid financial footing.
“We're built financially sound,” James Lynch, chief actuary of the III, said. “In the United States, we have $800 billion in surplus. Aside from the retroactive BI threat, it's clear the industry has the capacity to absorb the financial losses they're going to get from both directions—one direction being the losses they'll pay out and the other being the premium revenues they won't receive.”
That's no coincidence. Insurers got to this place because of past events.
9/11, Katrina, going back a little further Hurricane Andrew—those are the big events that have shaped the industry. This will be another one.
Parallels from the Past
Dave Ingram, author of Willis Towers Watson's annual report on the most dangerous risks, understands why pandemic fell off the list.
Insurers have experienced many health crises in the 21st century—SARS, avian flu, swine flu and the Ebola virus among them. But not since the 1918 Spanish flu has the world dealt with a pandemic of this magnitude.
“In the last 20 years, the danger of pandemic was always dissipated before it became an actual damaging event, at least to the insurance industry,” said Ingram, executive vice president in the enterprise risk management unit at Willis Re. “In any management situation, you can be concerned about things, but if they keep not happening, it's really hard to keep up intensity in preparing for them.”
Because COVID-19 is unlike anything insurers have experienced, it's hard to find parallels.
“There isn't a comparison to draw,” said Simon Oddy, partner and forensic accountant for advisory firm Baker Tilly. “There are only mini comparisons.”
The 9/11 terrorist attacks, cyberattacks and the financial crisis of 2008-09 are the most common ones.
“9/11 is the closest that the current generation of insurance professionals has dealt with,” Oddy said. “But the magnitude is not the same. The issues faced then were on a smaller level. …I can't believe we're saying 9/11 was a 'smaller level' than something.”
According to the III, the terrorist attacks led to $32.5 billion in insured losses ($47 billion in today's money). It was the largest single event loss in history at the time, but has since been surpassed by 2005's Hurricane Katrina ($52.8 billion today).
In early May, Willis Towers Watson estimated general insurance losses from COVID-19 could reach $80 billion across key business classes in the United States and United Kingdom. The company predicted the hardest-hit lines would be workers' compensation in the United States and business interruption/contingency in both countries. The latter, it said, could amount to $22.7 billion. The National Council on Compensation Insurance offered a staggering range of losses—$2.7 billion to $81.5 billion—for U.S. workers' compensation lines.
The similarities between COVID-19 and 9/11 extend beyond loss costs, however. The biggest similarity is in the way both events have crossed business lines.
“9/11 had workers' compensation claims, liability claims, some directors and officers claims, enormous property claims,” the III's Lynch said. “It was a tremendous business interruption event. Of all the lines that paid out, the largest payout was business interruption claims, according to some calculations III did at the time.”
The pandemic also has been likened to a cyberattack, not only because of its ability to reach across geographies and business lines but also because of its pace.
“The pandemic is like a massively slow-moving cat,” said Tom Johansmeyer, head of PCS, a Verisk business. “Cyber can have a long development period up front until it becomes a cat. We see pandemic showing similar characteristics.”
PCS, which is the arbiter on catastrophes for the property sector, is not tracking COVID-19 losses. But it is watching them closely.
“We have a standard threshold that we use for determining whether or not something's a catastrophe in the United States,” Johansmeyer said. “That's a $25 million industrywide insured loss, a significant number of insurers and insureds affected, and it's got to fit into one of our perils for storm families that are predefined lists. We don't have a category for infectious disease or virus. We're not going to add one on the fly.”
In terms of its widespread economic impact, COVID-19 draws comparisons to the financial crisis of 2008-09.
“In the financial crisis, you had a tremendous market downturn, a period of financial volatility and a very hard-hit economy,” AM Best's Holzberger said. “But even that was not at the same magnitude. That was a Wall Street-type of issue with contagion into other financial markets. The way this pandemic is hitting businesses, local economies, state and national economies from the ground up, truly is unprecedented.
“But a lot of the reason insurers are well-positioned right now is because of lessons learned in the '08-09 financial crisis,” Holzberger said. “'08-09 was in large part a liquidity event. Companies are more disciplined now in ensuring they have appropriate access to liquidity to pay claims, to pay off debt that might be maturing in their capital structure.”
Aside from the retroactive BI threat, it’s clear the industry has the capacity to absorb the financial losses they’re going to get from both directions—one direction being the losses they’ll pay out and the other being the premium revenues they won’t receive.
Insurance Information Institute
One of the first things AM Best did when COVID-19 hit was run a stress test. The III did the same.
“We ran a stress test across all of our ratings globally, assuming a downturn in the financial market,” Holzberger said. “We wanted to see what risk-adjusted capital looked like based on some of the downward investment performance that we had seen in the latter part of the first quarter and into the second quarter.
“The early indications were that the P/C companies held up quite well to the stress test. The life and annuity and health care companies that we rate required more analysis and more conversation with companies to get comfort that the rating was still appropriate. That's ongoing.”
The III's approach was a bit different. It modeled coronavirus plus the worst natural catastrophes on record. It wanted to know how the industry would fare if, on top of coronavirus, it suffered the worst hurricane ever (Katrina), the worst convective storm season ever (2011) and the worst wildfire season ever (2017). “Even with all of those things put together, the industry would have plenty of capital,” Lynch said. “It can weather this storm.”
That's not to say insurers aren't taking a big hit. First-quarter results showed evidence they are, particularly in their investment portfolios.
Berkshire Hathaway, for example, posted a $49.7 billion net loss attributable to shareholders, which was driven by investment and derivative contract losses of $70.3 billion.
Hartford Financial's net income dropped 57%, a decrease it attributed to $231 million in net realized capital losses.
“Many of the losses are being driven by realized losses on their investment portfolio,” Hartwig said. “That's because we entered the year on a bull market but by early March the market had turned bearish. On March 23, which is very close to the end of the quarter, we hit low points in the S&P and the Dow. Both indexes shed one-third over their value in the span of a little more than a month.
”At the same time, there were significant liquidity problems in the bond market, so bond values wound up plunging as well. These two factors drove the industry to realize capital losses in the quarter. Fortunately, April was a strong month for both stock and bond markets, so paper losses insurers sustained have been offset by recent gains.”
Insurers, however, are designed to withstand such volatility without any interruption in their ability to pay claims or provide service.
“The industry's preference and, in fact, requirement to invest in high-grade corporate and government bonds, meaning munis and Treasury securities, dates back decades,” Hartwig said. “This is why the industry will be able to withstand the financial volatility from COVID-19, and why it was able to withstand the global financial crisis in 2008 and '09, the economic turmoil that surrounded 9/11 and other recessions that occurred in the 1990s.”
The full financial impact of COVID-19 may not be clear for a long time, largely because insurers expect an onslaught of lawsuits relating to claims, but also because we're still in the midst of it.
“Normally when we deal with a big cat, at some point it ends, usually relatively quickly, and we can start the recovery process,” Baker Tilly's Oddy said. “The storm passes, you stand back and survey the damage, and you put into operation your recovery effort. But here we are in a storm that will not pass.”
Still, insurers already are thinking about the future.
“They're starting to talk about how we can be prepared for the next time,” RPS's Head said. “To me, this is a launching-off point for how to help ourselves and our clients prepare for something similar in the future, much like we did with terrorism after 9/11. This is going to change the way the insurance industry does business in the future.”
Though it's still early days, some clear lessons already are taking shape. For instance, the volume of claims from COVID-19, and the need to adjust them remotely in many cases, has brought insurtech into focus. The looming hurricane season will only exacerbate that. With above-average hurricane activity predicted for this year and COVID-19 expected to continue indefinitely, insurers will be managing crises within a crisis while also trying to meet policyholder expectations around customer service.
“The ability to deal with case volume, and the ability to deal with case volume at an accelerated pace, is so important,” Oddy said. “The lives we lead are accelerated. It's a double-click mentality in most walks of life; the new expectation is to have a massively accelerated process, whatever the process is. We're starting to see that in insurance, where there is a need for an accelerated response. This highlights that.”
Technology and analytics also could allow commercial insurance to take more of a usage-based approach, with policies audited regularly to ensure they reflect true exposure.
“We don't normally audit excess and umbrella policies,” Head, of wholesale broker RPS, said. “They're agreed to at the beginning of the term, and no matter what happens that premium stays the same. I believe insurance is going to be much better at using analytics to show what the true risk is.
“For example, if you're in the hospitality industry and you operate 12 months, and you're going to be down for three months due to this pandemic, your excess and umbrella policies should reflect that because exposure is down. Technology is going to allow us to do many more things on the spot.”
The pandemic also spotlights the need for nimble underwriting that reflects new risks. The COVID-19 outbreak has prompted business owners to adjust their operations, with sit-down restaurants becoming take-out restaurants and automobile manufacturers shifting to producing medical supplies. Such changes alter exposures and risk profiles, particularly on the casualty side.
“If a restaurant is closed, we need to pivot and cover it as a vacant property,” Head said. “Or we have to consider whether a restaurant has new exposures, such as hired and non-owned auto, which we're seeing a lot of because restaurants are doing more delivery.”
Because these shifts could be temporary, insurers need to be flexible in crafting coverage. Head said many have been.
“A lot of our carrier partners have put some really good coverages together for this hired or non-auto exposure that more than likely won't go on more than six or nine months,” Head said. “So they're writing three-month policies for folks.
“We're already starting to adapt, and I'm very proud of our industry.”
Muir-Wood, of RMS, expects to see a lot of creativity emerge from this period.
“It's always been the case that in the aftermath of the largest catastrophes, the largest innovations occur and whole new lines of business for the insurance sector turn up,” he said. “This is exactly that moment.”
Once they catch their collective breath, insurers are likely to begin looking for ways to address pandemic risk, both through some form of public-private partnership similar to the Terrorism Risk Insurance Act and through new products. The latter will be more a dipping of the toe, experts said, as the industry remains firm in its belief that pandemic risk is uninsurable on a broad scale.
“I certainly expect, as there was after 9/11 and Katrina, an examination of contract language,” Hartwig said. “You will see some adjustments to contract language, which will be responsive to litigation against the industry, that will seek to make the language even more crystal clear than it is today. Today we might characterize exclusions for microorganisms such as viruses and bacteria to be ubiquitous. In the wake of this, they'll be universal.
“With a universal virus exclusion in place, you'll likely see insurers begin to experiment with coverages that would provide some limited amount of coverage for pandemic events in the future,” Hartwig said. “In the same way insurers have learned from past cyber events and developed products based on their understanding of those events, and worked very carefully to contain their exposure for those types of events, there is a possibility they could also do that with respect to pandemic.”
Parametric products are the early front-runner for doing so.
“With parametric triggers, you front-load the work,” Baker Tilly's Oddy said. “You've done your homework and preparation even before there's a loss event.”
Johansmeyer, of PCS, said industry loss warranties could be “a very elegant solution” for business interruption.
“BI claims are fairly complex to adjust,” he said. “You need lawyers, you need forensic accountants, you need a lot of expert support. Those things take time. Parametric works out really well because you don't need any of that. You use some collection of authoritative data sources. Once the threshold is reached, payment is made, so loss adjustment expense goes way, way down. It becomes a lot easier to manage.”
RMS created a pandemic model for business interruption in 2008, Muir-Wood said, but didn't bring it to market because demand for it at the time was limited. There likely will be some interest now, and that model can serve as a skeleton for a new one.
“That 2008 model was built to the knowledge at the time,” Muir-Wood said. “That learning can be incorporated into what we offer. We will work closely with sectors of the insurance and reinsurance market to find out what their appetite is.”
While Muir-Wood said there “definitely will be” interest in creating new parametric solutions, those conversations have remained on the margins thus far.
“There's so much more for the industry to focus on right now,” he said. “We are like people in the middle of the hurricane. But a hurricane might take two or three days to go past, whereas COVID will take a year to go past. So we've had some conversations, but it's not the priority right now.
“It will become the priority, though.”
The insurance industry can either easily absorb COVID-19 losses or fall in ruin as a result of the pandemic. It all hinges on one thing—business interruption.
Business interruption is the X-factor in the industry's ability to withstand the COVID-19 catastrophe. As of early May, seven states had introduced bills that would require insurers to pay business interruption claims stemming from COVID-19 closures, including some measures explicitly overriding exclusions within contracts. If those measures are passed and upheld, it would devastate the insurance industry.
In a Best's Commentary, Legislation to Nullify BI Exclusions Poses Existential Threat to P/C Insurers, AM Best said the legislation could cost insurers $150 billion to $200 billion per month. The Insurance Information Institute and American Property Casualty Insurance Association place the estimates much higher. The APCIA forecast losses of up to $668 billion per month, while the III estimated retroactive BI could cost the industry up to $380 billion per month.
“That's an industry-breaking event,” James Lynch, chief actuary for the III, said. “That would break the industry in two directions. One, the financial load it would place on companies to have to pay claims they had priced the business for, and had specifically excluded, would create financial ruin. Moreover, that intervention into clear policy language would call into question the entire insurance business model.
The State of New York cannot alter the laws of physics to satisfy its trial lawyer masters. That’s essentially what happened. They developed this language in an attempt to override the virus exclusion.
University of South Carolina
“Insurance at its core is a promise, and that promise is embedded in a contract. If a third party can come in and rewrite the terms of that contract to suit its own purposes, you have to wonder whether anybody would ever want to write a business interruption policy again or, beyond that, what other lines of business might be threatened next time political actors decide insurance should pay for some things it never promised to pay for.”
On the federal level, members of the House of Representatives sent a letter to insurance industry groups requesting insurers cover business interruption losses. On the state level, legislators introduced the seven retroactive BI bills. On the local level, several prominent city mayors specifically stated in their emergency orders that COVID-19 caused physical damage and loss to businesses.
“They're trying to make the case that they're shutting down because of physical loss and damage from the virus,” said RiskGenius CEO Chris Cheatham, whose company uses software to help insurers evaluate policy language. “That's not an accident. That's not how people talk.”
Bob Hartwig, director of the Risk and Uncertainty Management Center at the University of South Carolina's Darla Moore School of Business, said politicians were fed such language from plaintiffs' attorney groups who are “looking at this as a potentially huge payday.” Still, he said, just because an emergency order states something doesn't make it true.
“The State of New York cannot alter the laws of physics to satisfy its trial lawyer masters,” Hartwig said. “That's essentially what happened. They developed this language in an attempt to override the virus exclusion.
“All legal scholars agree this will fail a Constitutional test. There's no question about it.”
The battle over business interruption will, without doubt, make its way into the courts. And most agree the courts will side with insurance companies.
“The exclusion for viruses is not an ambiguous one,” Lynch said. “It's an exclusion of loss due to virus or bacteria. When it was filed, the filing specifically mentioned the potential for a pandemic similar to SARS CoV-1. And the current pandemic is SARS CoV-2. So I don't think there's a lot of ambiguity here about what the exclusion was meant to exclude.”
Stefan Holzberger, chief rating officer of AM Best, agreed.
“Those well-defined, long-instituted, regulator-approved exclusions for pandemics or viruses should hold,” Holzberger said. “The business interruption policies that have that exclusion, which is the vast majority in the U.S., should not have to honor claims associated with a loss of revenue related to COVID-19. If the legislators actually push through that legislation, it will go to the courts.”
Perhaps all the way to the Supreme Court.
“Nullifying or changing a fundamental aspect of a contract has incredibly broad implications for doing business in the United States in any industry,” Holzberger said. “Every industry relies on the sanctity of a legally constructed contract. It's inconceivable to think that could be thrown into the garbage. But if that were to happen, we would see widespread insolvency because the magnitude of lost revenue in relation to the capital surplus is so great. The insurance industry could not bear those losses. Which is why they weren't covered in the first place.”