Having worked in insurance since the early 1980’s, the one thing hard markets have taught me is that they rarely have the same trigger but the fundamental effects are fairly similar: Property classes suffer in the short term but liability classes suffer for longer. The consequences of the COVID-19 outbreak will most likely follow this pattern.
The insurance sector uses the term “hard market” for a period where risks are tough to place and prices rise quickly. In my career I have seen three hard markets in London: 1985, 1992 and 2002. It is remarkable that the current down cycle has lasted as long as it has.
Drivers of the capital squeeze
In all my years in the insurance industry, clients and insurance markets have always discussed hard markets in terms of poor loss records but the reality is, true hard markets rarely result from losses only. Instead, they generally result from a lack of capital when it is needed, and it is very likely that insurance markets will be starved of capital when COVID-19 losses hit their balance sheets. Interest rate declines combined with a drop in equity markets and potential corporate bond losses due to the COVID-19 outbreak will weigh heavily on the entire insurance industry as investment returns decline.
Insurers write premium income off the capital they deploy, so lower capital will therefore reduce underwriting capacity. The reduction of insurers’ capital is likely to come from two sources:
1. There is no doubt insurance losses as a result of COVID-19 will have an effect on capital. Generally most insurers were already writing above a 100% combined ratio (a ratio below 100 percent indicates that the company is making an underwriting profit), and were struggling to bring this rate down. Whilst it is currently hard to assess the losses resulting from COVID-19, it will certainly cause insurers’ combined ratios to spike well above 100%. In the short term insurers will need to pay out a lot of cash. Consequently, insurers will either need to raise more capital or reduce underwriting.
2. Insurers will feel the impact of investment losses on their capital. Most insurers invest in the equity markets and the corporate bond markets. Even Lloyd’s, which traditionally used to invest most of their capital in the safe haven of government bond markets, following reconstruction and renewal of the Lloyd’s market in 1993, which introduced corporate capital to the market, investment criteria were relaxed and equities became a larger portion of corporate syndicates’ portfolios.
To illustrate the latter: Lloyd’s has just announced its results for the 2019 financial year which showed a profit of just over £2.5 billion on the back of a 102.1% combined ratio. Profits came from investment returns of £3,537 million, up from £504 million in 2018, a 600% increase. With worldwide stock markets showing falls of over 20% YTD in 2020 and corporate bond markets likely to suffer losses, insurers are going to post some sizeable losses on their balance sheets in the coming quarterly results as investment returns drop. Fitch has just placed Lloyd’s, along with many insurers, on a negative credit watch as a result of these concerns.
Will the insurance sector find new capital sources following the COVID-19 crisis? The financial crisis of 2008 saw quantitative easing and a large influx of capital into the financial markets, a lot of which did make its way into the insurance sector which was perceived as counter cyclical, meaning large insurance catastrophe losses rarely coincide with financial market dislocation. The London Market benefitted particularly from capital coming from Asia. This proved true in 2008 but not always. Hurricane Andrew in 1992 came at a time of very difficult financial markets and this contributed to the hard market in the 1990’s, despite the arrival of a lot of US capital in the London Market. In a similar way, insurance losses from COVID-19 are likely to coincide with high stress levels in capital markets, so fresh capital is unlikely to be easily accessible, particularly since the pandemic has impacted economies and financial markets worldwide.
Consequences for insurance buyers
While it is always hard to predict markets, the fundamentals remain the same: Where there is a lack of capital, insurers must reduce their premium writings. If insurers follow this pattern following the COVID-19 outbreak, they will start re-allocating capital to match their writings, giving preference to the areas where they can see the fastest return. This will most likely be in the property insurance market and in catastrophe reinsurance. Without any meaningful catastrophes (and that is not a given), insurers can affect their performance and their combined ratio’s fastest by using the large price increases expected in the short tail market to improve performance, where claims are made and settled quickly. Price spikes in the short tail market therefore tend to be stronger but also shorter in duration. Most short tail hard markets last two to three years before an influx of capital pushes prices lower again (in the absence of major catastrophes).
Working in the professional indemnity insurance field I need to point out that the preference for property insurance and catastrophe risks after a market shock can cause serious issues for the liability insurance classes. Many insurers pull out of the so called long tail classes when capital is squeezed, arguing that long tail insurance classes are not core to their business, profitability is not satisfying and they see no short term change in that.
Insurers that continue underwriting long-tail risks will likely face rising prices but their capacity to underwrite will be limited. It is not unseen that insurers reduce their line by half when prices double as they run out of capacity. Alongside price rises we will see changes in the terms and conditions in liability insurance. During the past soft market that lasted several years, policy wordings have widened substantially, since pricing could no longer attract business. We have already seen this trend reversing but the pace is now likely to increase.
Prices in some liability insurance markets have already risen in 2019 and early 2020 and COVID-19 is likely to increase the speed and spread the trend to other areas.
Finally, I would like to share some recommendations to help insurance buyers avoid the impact of the wider swings in the market when purchasing liability insurance:
1. The smaller the limit you buy the lower the effect of a hardening market. Many underwriters are reducing the size of lines they write and the effect of reduced capital will make larger limits much harder to place. As capital restrictions start to bite, finishing the larger programmes could see the last line to go down to be the most expensive! Be realistic about your insurance requirements.
2. Consider fee options for your broker! Fees do not attract insurance premium tax.
3. Deductibles – this will depend on the class. The lower the frequency of loss in the class the less benefit underwriters will give for increasing retentions. Having said that, ask for terms for higher retentions. Reasonable Insurers that want to maintain your risk will look to alleviate price increases by offering bigger discounts.
4. Check your broker. Many brokers in insurance today, after an 18 year down cycle, have never experienced a hard market! Does your broker know how to handle hardening markets if he has never experienced it?
5. Wordings will most likely be subject to change. It is a legal requirement that your broker provides you with a detailed analysis of any changes to your wording. Ask for a list of the material changes.
6. Get in early with you renewal information – The longer the broker has to negotiate alternatives the better the outcome.
7. Consider when your policy renews – Past hard markets have seen risks renewing after the summer period, start to suffer higher premium increases as income and capacity restrictions affect insurers’ ability to renew or to provide alternatives. Is it worth taking early cancelations and replacing your cover or extending the policy to a different renewal date?
For further information, please contact:
Brian Horwell, Retail Producer
Email: Brian.Horwell@uk.lockton.com (opens a new window)
Tel.: +44 (0) 20 7933 2846
