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What can insurance buyers expect in 2021?

Captives|Risk & Analytics|Corporate Risk Tools and Technology|Credit, Political Risk and Terrorism|Environmental|Financial, Executive and Professional Risks (FINEX)
Climate Risk and Resilience|COVID 19 Coronavirus|Geopolitical Risk|Risk Culture

By Marc Paasch and Vittorio Pozzo | January 14, 2021

Amid a challenging insurance market, insureds should take an enterprise-wide view of risk, bringing together risk, financial and technology leadership.

By any measure, events in 2020 rearranged the risk landscape in unprecedented ways. Amid the COVID-19 pandemic, organizations had to manage the effects of a recession, the rise of economic nationalism, climate change and other challenges.

The insurance industry, meantime, worked to keep up with emerging risks and rising claims with balance sheet pressures compounded by record low interest rates and a negative yield curve, heightened regulatory oversight and competition from other sources of risk financing.

At this writing, a newly developed COVID-19 vaccine promises to restore some economic stability. However, it is clear that 2021 will continue to be a challenging time for the insurance industry and its clients. We expect:

  • Additional hardening in major insurance lines, especially those with COVID-19-related exposures such as directors’ and officers’ liability (D&O), professional indemnity, property and business interruption
  • Accelerated use of alternative risk financing techniques, including structured, parametric and portfolio solutions
  • Heightened pressure on insureds to improve enterprise resilience in a framework that includes meaningful environmental, social and governance (ESG) compliance and effective business continuity management

Effective COVID-19 vaccines may be broadly if not universally distributed by the second or third quarter of 2021, with some general expectation that business operations and financial markets will return to normal. But this depends on how one defines “normal.”

The virus accelerated major changes in business models for many industries as employees lucky enough to keep jobs were forced to work from home, shop online and cancel nonessential travel. Rocket Internet, Amazon, Alphabet, Spotify and other technology companies may have benefited, but some industries – construction and real estate, transportation, consumer retail, etc. – will emerge from the pandemic in altered form.

Global geopolitics impact on trade

Global geopolitics also continue to change, accelerated by nationalistic impulses as seen in President Trump’s “America first” administration and Brexit. Even under a new president, the U.S., like many of its allies, may back away from some of the free-trade policies of recent years. These actions in part reflect China’s rise as a major economic power and rival as seen by some countries, with security fears surrounding Chinese-developed 5G networking equipment. Many companies already are reshaping supply chains and forging new business relationships in this environment.

Even as COVID-19 comes under control, these political and economic trends will complicate a projected global economic recovery in 2021 – a recovery that Goldman Sachs described in a November 2020 forecast as a “V(accine)-shaped recovery.” The investment bank expects global growth of 6%, adjusting for regional variations. Real GDP growth is expected to reach 5.3% in the U.S. and Euro area, with the U.K. GDP growth projected at 6.1%.

The bank further expects subdued inflation with “dovish” monetary policy forecasts for both the U.S. and Europe. Investment returns are projected to exceed 4% in 2021 after a dismal 2020. But for insurers and other companies cash flow will remain a priority.

Enhanced focus on resilience

COVID-19 and its disruptive impact on business will accelerate corporate resilience efforts. Although the idea of resilience has been kicked around corporate offices for years, the virus has added a greater sense of urgency. We therefore expect 2021 will see new efforts to build genuine resilience into business strategies and operations.

According to the Boston Consulting Group, in the shock-recovery trajectory, resilient companies enjoy better outcomes than their peers. The value of resilience tends to be higher in industries that face deeper or more frequent crises.

While the value of resilience is greatest in technology and consumer durables sectors, which have tended to be more volatile, it is lowest in industries with more stable demand, such as food and beverage, household products, and health care food and beverage, which is the lowest industry for value of resilience.

The resiliency needed for disruptive or even “black swan” events should extend beyond risk governance and risk management and be integrated with other operations, including finance and technology. In many companies, these areas work independently of each other, limiting risk management effectiveness.

Regulatory challenges ahead

Regulation will continue to be an issue. In the U.K., for example, listed companies need to declare they have good systems of risk control that are reviewed annually. The U.K.’s Financial Reporting Council’s viability statement requires directors to quantify future risk exposures and compare with capital holdings. Such efforts will expand in other countries.

Adoption of ESG principles also will become unavoidable for many companies and extend beyond heavily regulated business segments as countries move to address underlying ESG issues. A market initiative, the Task Force on Climate-Related Financial Disclosures, will provide another opportunity to manage risk within an ESG framework.

Pressure is likely to persist from clients, shareholders, governments and other third parties who expect a business continuity plan (BCP) that will maintain a client's core business after a disruptive event. BCP plans, previously used to restore existing operations, will need the flexibility to accommodate evolving business models or even be radically transformed. A simple illustration from the COVID-19 experience is the effort by many restaurants to develop take-out and delivery services when they are unable to seat customers in the traditional restaurant environment.

Companies also will pay more attention to each business impact analysis, a key element of business continuity planning. The COVID-19 crisis has been a stress test that many executives failed. Although a pandemic may have been listed among business threats, few companies engaged in scenario planning and related preparations. We expect to see companies establish a higher level of preparedness for potential major risks.

Cyber risks: Here to stay

Major risks obviously will include cyber and IT recovery plans as businesses and consumers worldwide depend increasingly on digitalization. Cyber risks (and how to deal with them) are the top priority of any company that depends on cyber technology, including artificial intelligence, to develop and deliver their products and services. Exposures include:

  • Growing security and privacy issues that spur pressure for regulation and are of growing concern to customers and business partners
  • Digitally dependent smart supply chains that can be targeted by hackers, rendering them “dumb”
  • Data-rich consumer devices that are multiplying faster than they can be secured
  • Unexpected new candidates for cyberattack, including vehicles and transport infrastructure
  • Businesses that will face increasing ransomware attacks

Cyber infrastructure, both in the cloud and in localized information technology, increasingly will be included in disaster recovery plans, the documented process or set of procedures to execute an organization's disaster recovery processes and recover and protect a business information technology (IT) infrastructure in the event of a disaster.

A data or IT disaster recovery plan should be a core element of the business continuity plan and tested periodically to ensure it works. A plan typically includes:

  • IT recovery strategies, including hardware, software, data and connectivity to a service provider
  • Suitable computer room environment (climate control, backup power supply, etc.)
  • Vendor-supported recovery and off-site backup, if necessary
  • Ability to identify critical software applications and the data and hardware required to run them

Expect rigorous insurance underwriting requirements

In 2021, insurers will apply increasingly rigorous underwriting requirements as key insurance lines continue to harden. In this environment, clients will need to step up efforts to better collect and interpret data around risk exposures and loss experiences.

One promising trend is the effort by many companies to apply a standardized engineering and loss prevention process across all locations and lines of business. The process is most effective when it includes data-mining solutions that will enable risk managers and their advisors to identify, prioritize and manage exposures that may have material impact on operations and revenues.

Many current data-management capabilities fall under risk management information systems (RMIS) with capabilities that might range from the basic functionality of a Risk Intelligence Central portal to systems with additional capabilities for reporting and data insights.

A growing need for advanced analytics and risk technology solutions

RMIS capabilities may not offer adequate analytics and, even less likely, predictive analytics. Data insight is for now limited, and the typical RMIS definition of “predictive” is simply trending forward an estimate rather than providing a range of possible outcomes. In the risk management space, we consider it unwise to call any one number a “prediction” as it ignores variability – the very essence of risk.

Loss control data will be boosted with the use of cognitive technology, an offshoot of artificial intelligence. Advancements in cognitive technologies, artificial intelligence and data analytics are helping organizations go beyond traditional ways of managing risk by using smart machines to detect, predict and prevent major risks.

More insurers will consider or deploy cognitive and related technologies to use data for product development. An example that will proliferate is usage-based insurance, including pay-by-stay insurance for home-sharing services, such as Airbnb. Slice Labs provides variable commercial insurance specifically tailored for home sharing.

Risk assessment is largely inward focused as compared to being forward looking and externally focused. Detailed analysis of competitor strategies/benchmarking and scenario planning are not widely used for the emerging risks. Organizations will increasingly evaluate “unknowns” by identifying exposure and correlation between external trends and risks that could ultimately result in a catastrophic impact on their enterprise viability.

Insurance rates will continue to rise

As noted above, insurance pricing will remain hard or harden further for major lines, including D&O, professional liability, property and business interruption.

Larger corporations will attempt to mitigate premium increases by reducing former “full value” limits to estimated maximum loss (EML) and maximum foreseeable losses (MFL) for fire/explosion damage as well as natural catastrophe. As EML/MFL estimates become more critical, they will need to be generated not just for fire and explosions but also for natural catastrophe perils – an expanding risk area.

Insureds will need to continue to re-examine risk finance strategies with the aim to create savings in total cost of risk, with dual renewal and risk-financing strategies. What constitutes “material” risk must include new risks, including trade credit, affinity and employee benefits, among other things.

Alternative risk transfer solutions

Alternative risk transfer (ART) products (e.g., structured, parametric, portfolio and captive solutions) will continue to offer options in 2021’s hard market. However, ART markets are not immune to the economic pressures of their traditional colleagues across the commercial insurance market, with pricing increases often reflecting companywide edicts rather than the risk itself.

ART deal committees will continue to act conservatively, displaying a preference for simpler deals versus cutting edge, and the decision process will remain protracted in many cases. Deals presented in detail, supported by robust analytics and on realistic time frames, will fare better.

The focus of structured solutions will continue in property & casualty lines of business that traditionally have embraced a risk-financing approach. However, insureds are increasingly applying this across multiple lines of business, using the market to help manage the cash-flow impact of large losses while securing risk transfer capacity for remote loss scenarios.

Parametric solutions will become more common for companies facing risks from such potentially huge and unpredictable risks as natural catastrophe and weather.

With COVID-19 on top of a challenging property market, parametric tropical cyclone and earthquake programs became very popular in 2020, and this trend is likely to continue. These programs can complement the property placement by in-filling deductibles, topping up sublimits or covering uninsured risks.

Parametric weather index products that address extremes of precipitation, temperature, humidity, snowfall, and the like, are increasingly being adopted by insureds (i.e., public entities as well as corporations of all sizes) to hedge against typically non-damage business interruption events, especially with increasing concern over climate change.

Insurers will continue to embrace more generic industry indexes (RevPar, for example), which may be correlated to a number of risks as well as the insured’s own data. For a company facility destroyed in a forest fire, say, the indices allow the business interruption component of a property claim to be settled on a parametric basis, simplifying the claim settlement process with claim settling in days verses months or years.

Capacity for portfolio solutions (or integrated risk programs) is diminishing in the current market as ART units are forced to adopt the same underwriting restrictions imposed on their monoline colleagues. However, those insureds that have established programs are benefiting significantly from being insulated from market volatility and rate increases, at least until such programs renew.

Captive innovations

Captive innovations will continue. One of the major current hot topics having an impact on captive operations is the OECD Base Erosion and Profit Shifting project. This puts captives under the spotlight in three key areas:

  • Economic rationale: Risk/Reward and employment of assets compared to profits – does the arrangement make financial sense?
  • Substance: Is direction, management and infrastructure in place commensurate with profit creation?
  • Transfer pricing: Is the arm’s length principle being appropriately applied – can transactions be independently benchmarked?

Another topic relates to the captive rationale and re-domiciliation. Captives have been reviewing their operations in order to assess the application of “arm’s length” requirements and review their captive rationale and alignment of organizational structure.

In many cases this has led to a re-domiciliation and a rising trend in captives moving to the country of the parent company. This is happening in some cases even where it is a financially suboptimal move due, for example, to the absence of captive legislation in those countries.

Another consequence in the case of the OECD’s Transfer Pricing Guidance is that it is leading to captives reviewing and potentially reducing their loans to parent. Captives are undertaking a related-party loan review to ensure that loans will remain compliant and eligible.

More sophisticated captives will continue to look for ways to enhance their return on capital. Where assets are not lent back to parent companies, they are typically invested in very low risk and low yield assets. Following the lead of pension funds and commercial insurers, captives are starting to become more adventurous and undertaking asset allocation reviews. Large and wealthy structured captives might consider releasing captive surplus to support COVID-19 loss funding.

Other trends we expect to see in 2021 and beyond is the use of captives to manage coverage gaps, trade receivable-related risks (e.g., trade credit) and to attract new revenues by writing third-party risks (e.g., employee benefit, affinity business).

We also expect the rapid growth of so-called hybrid instruments to cover certain major impact risk events such as natural catastrophe and climate change, political unrest, terrorism and cyberattacks. (A contingent convertible bond is one example.) A combination of insurance and financial solutions, hybrid products can involve any industry as a potentially cost-effective way to transfer complex risks.

Preparing for 2021

Risk management professionals and other business leaders increasingly will face new and emerging risks that may range from spurts of hyper-nationalism and pandemics to cyber, climate and intellectual property risks. After reviewing this risk landscape, we draw some important conclusions:

  • Determining a company’s risk appetite and risk tolerance should be the first step for those organizations that are seeking risk management and risk financing optimization during a time with rapidly emerging and evolving risks.
  • Hardening insurance market conditions are going to continue in major lines of coverage. Organizations should prepare by detecting, analyzing and managing both existing and emerging risks by using all the necessary analytical and advisory tools. Alternative risk transfer solutions and captive insurance strategies will no longer be a luxury but, under certain risk circumstances, a necessity.
  • Organizations should be equipped with technology, data and analytics to back up risk management decisions with sound analysis that should embrace a wider spread of risks, from ESG and climate to cyber and business continuity risks. At the same time, any project triggering unforeseen, or unbudgeted, costs will be challenged harder than in the past due to higher pressure to reduce spending in light of the pandemic and subsequent business and monetary implications.
  • An ESG framework should be implemented as a foundational solution, together with business continuity management plans, for organizations to stay resilient.
  • Organizations should understand the dynamics behind the hardening insurance market and work with their advisors to design optimal protection programs by considering a risk portfolio approach.
  • Senior executives should focus on updating their business impact analysis and making their supply chain more resilient to disruptive events and challenges like pandemic and climate change.

It can’t be said enough that senior company management must assert responsibility for the development, communication, monitoring and updating of the risk appetite framework and risk mitigation within an enterprise business context that brings together risk, financial and technology leadership. This will be the single most vital factor separating highly successful companies from the also-rans.

Authors

Managing Director
Global Head of Alternative Risk Transfer Solutions
Global Head, Strategic Risk Consulting

Captive Advisor, Western Europe and Great Britain

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