Diverging Views: Is COVID a One-Off Catastrophe or Not?

By | June 5, 2020

Speaking at the Casualty Actuarial Society Virtual Spring Meeting on May 11, Sherman Power, the U.S. ReSolutions Leader at Aon, put a big number on the equity markets view: $300 billion.

That’s the amount that publicly traded large cap property/casualty companies lost in aggregate market capitalization from Jan. 1 to May 1, 2020, he said during a session, Risk Management in Light of the Coronavirus Pandemic “By itself, [that] is probably an order of magnitude larger than any current estimates of COVID-19 underwriting losses,” he said, noting that the figure only represents the lost market cap for a subset of the P/C universe.

In fact, Power showed a chart listing first-quarter underwriting impacts announced by 18 P/C insurers and reinsurers, which added up to just $1.4 billion—a fraction of the $300 billion figure. (Editor’s Note: Carrier Management did the addition.)

Carriers and reinsurers were describing the COVID-19 impact as a one-off “typical catastrophe in terms of expected losses” during earnings announcements that were released in the days and weeks prior to the Power’s presentation, he reported. “So, clearly, we’re seeing a big disconnect between what the capital markets are saying is our industry exposure and what a one-time cat event looks like.”

AIG Takes Hit from Coronavirus in Q1; Sees Industry’s ‘Biggest CAT Loss Ever’ Ahead

“We believe COVID-19 will be the single largest CAT (catastrophe) loss the industry has ever seen,” AIG CEO Brian Duperreault said.

Why the disconnect?

“It’s only a guess at this point, but possible explanations could include [the] vast range of uncertainty around business interruption coverage…There are [also] recessionary impacts going on. Another potential cause here is [the] double hit” to assets and liabilities that P/C insurers are experiencing. “Perhaps some underperformance is related to insurers facing both asset value losses and underwriting losses at the same time,” he said.

Speaking specifically about the reinsurance market, which is one of many sources of capital that carriers can rely on if those double hits impact their surplus levels, Dustin Loeffler, a casualty actuary and managing director at Aon, said that reinsurance markets “are continuing to message robust platforms. Out of all sources of capital that [primary] companies have, the one least impacted to date has been capital provided by reinsurance.”

In earnings announcements, executives are saying that this pandemic, “so far, is akin to a typical cat—to a hurricane loss or a bad tornado loss. So, at this point it’s more of an earnings issue and not so much of a capital issue,” Loeffler confirmed.

“Clearly, we’re seeing a big disconnect between what the capital markets are saying is our industry exposure and what a one-time cat event looks like.”

“We continue to hear reinsurance markets say they’re open for business and they’re wanting to continue to see deals,” Loeffler added. He noted, however, that Aon has seen a significant hardening of the property reinsurance market in recent weeks, “specifically in Florida, with some possible capacity issues there.”

“How much of that has to do with the pandemic, or with reinsurers deciding they want to get paid more for Florida capital, I think is yet to be determined. But that’s an example of one marketplace that is seeing possibly some retrenchment of capacity during this pandemic.”

Uncertain Claims Payouts

Two insurance coverage attorneys—Tancred Schiavoni and Zoheb Noorani of O’Melveny & Myers—offered some reasons for the uncertainty with respect to insurers’ business interruption payouts that could be spooking equity markets.

Citing prior case law, the lawyers went over some of the more widely discussed questions that make carriers’ ultimate exposure hard to pin down: Is there physical loss or property damage? How can plaintiffs prove the presence of the virus? Do the shelter-in-place orders prohibit access to the premises, giving rise to civil authority coverage?

Noorani also offered a less-discussed question for carriers that may, in fact, pay out claims under the business interruption coverage parts of property policies: What’s the damage dollar amount?

“This is a unique situation. Even if no governmental order shut down a property, because there’s a weakness in demand, most properties like restaurants or tailors probably would not be profitable,” Noorani said. “So, how do you measure the damages? Is it the lost income that would have been earned if the pandemic never happened? Or is it the lost income that would have been earned had the business stayed open during the pandemic?”

For his part, Power leaned toward the double hit from asset value movements and underwriting losses as a key factor contributing to the dim view of P/C insurers in the equity markets. “In terms of lessons from this pandemic, if there is a next one, this [asset-liability] correlation is a big lesson for our industry.”

How do you measure the damages? Is it the lost income that would have been earned if the pandemic never happened? Or is it the lost income that would have been earned had the business stayed open during the pandemic?”

Giving another illustration of the equity market view of the P/C insurance industry, he showed a graph with market valuations for the S&P 500 and a group of P/C insurers over recent months. “The S&P has retraced half its ground that it lost since the depth of the market,” he said, observing a volatile line indicated a 16.5 percent drop in the market overall as of last April compared to a diverging P/C sector that was down more than 30 percent.

Power displayed a chart showing high interest rates on fixed-income corporates in mid-March. “Interest rate increases on bonds suggested initially a large hit to surplus from fixed-income concentrated portfolios of P/C insurers, he said, noting that the high interest rates displayed corresponded with significant bond price drops. “The peak of the chart is where the Fed [Federal Reserve] stepped into the market and provided liquidity by buying corporate bonds,” he said, displaying a graph indicating the speed at which bond prices were deteriorating before that.

“So, for the next [pandemic], we might fear this correlation of asset prices and underwriting losses, seeing where things were headed prior to the Fed action,” he said. “It turns out it’s a very big deal in our industry when underwriting risk and asset risk are correlated. It’s often said of our industry [that] our management of those two risk pools could be better integrated, as I think this event is probably going to show.”

While surplus declines do not appear to be an issue for this pandemic based on individual carrier and rating agency reports, Aon is looking at ways to help going forward—”and certainly we’re looking at how reinsurance capital helps mitigate that,” Power said, later turning the presentation over to Loeffler, who provided examples of how reinsurance could be used to shore up Best Capital Adequacy Ratios.

Before that, Power provided yet another analysis of the market view of COVID-19’s impact on insurers, this time graphing price to book values (using 3/31 book values) in an attempt to “tease out” the effect of valuation changes in the asset prices. On this graph, the lines displaying median price-to-book values for both personal lines carriers and commercial lines carriers fell well below other industry sectors (small and large cap specialty insurers). “The market is treating this differently than a one-off cat event given the size of the market cap losses implied by the share price drops. There’s much more going on in the equity pricing here than we would expect for a one-time cat event,” he reiterated.

Meanwhile, only a handful of companies disclosed potentially material underwriting impacts in commentary released with their earnings reports, he said, noting that impacts depend on the concentration carriers had in a narrow set of coverage lines: credit, travel, life and health, event cancellation, and business interruption. To the extent there is expanded impact in these and other lines, such as workers compensation and other liability, “it might still be too early to tell, [but] it hasn’t yet made it into any of the [earnings] estimates in any concrete way,” he said.

In fact, Wall Street analysts factoring underwriting impacts into full-year 2020 earnings-per-share estimates lowered estimates by only 7 percent for the industry as a whole between mid-February and mid-April, Power reported, noting that the consensus EPS for personal lines insurers actually rose 9.5 percent.

New Solutions Needed

One “takeaway of a 7 percent earnings event for this industry is [that it is] obviously just a tiny fraction of the overall societal cost of this pandemic. So, it makes the point that in terms of risk bearing, we as an industry probably have to face it: We weren’t in a big part of the solution, a small part of the solution even,” he said.

“We’re going to have to explore solutions that go beyond what our current model is around post-loss indemnification and instead drive mitigation to maybe bring losses to a level within our capacity to absorb as an industry.”

Wrapping up his remarks with some takeaways, Power repeated that “the current equity market reaction and how insurance companies have been impacted to date seems to be speaking to more to come that hasn’t quite been reported yet.”

“In the big picture, what we’ve seen from this is that if we’re going to be a player in pandemic risk as an industry, first we’re going to have to find solutions to deal with the asset side correlation in a pandemic. That turns out to be a pretty big deal.”

“Second, there is not a clear path to providing coverage for the next one given the systemic nature of these losses, and then given the sheer size of societal loss relative to what we as an industry can absorb. So, going forward, if we’re going to find a way to provide coverage, we’re going to have to find deeper risk pooling mechanisms…We’re going to have to explore solutions that go beyond what our current model is around post-loss indemnification and instead drive mitigation to maybe bring losses to a level within our capacity to absorb as an industry,” he suggested.

Reinsurance Capital Buffers

While both Power and Loeffler said that they weren’t seeing a great need for capital relief solutions among primary carriers yet, Loeffler anticipates some in the second quarter. “To the extent companies continue to increase reserves as a result of this [pandemic], that could impact their capital positions,” he said.

He noted that in late March to early April, before a partial equity market rebound and the Fed action described by Power, Aon was seeing roughly a 20 percent reduction in the capital and surplus positions of some companies. While most carriers’ capital and surplus levels are now within an acceptable range, some companies might want to rebuild a buffer so they won’t be vulnerable to future shocks.

Explaining the pandemic’s impact on net required capital components of regulatory and rating agency solvency and strength assessments, he noted that lower investment values and possibly less premium work to reduce NRC, but downgraded bond holdings and decreased diversification benefits work in the other direction.

Giving a specific example for a company with a pre-crisis capital of nearly $1 billion ($916 million) and a BCAR ratio of 54 percent at the VaR 99.6 confidence level, he said a 20 percent reduction in available capital would bring that BCAR down to 49 percent. To get back it back to 54 percent, an expensive solution is to raise equity or debt—attacking the available capital (AC) portion of the BCAR calculation. A more cost-effective solution is capital provided by reinsurance—attacking the NRC, he said. (Editor’s Note: A simplified BCAR calculation is essentially AC – NRC/ AC)

Loeffler noted that potential reinsurance solutions are those that work on the reserve component, the written premium component or the catastrophe component of the NRC calculation. “Figure out which is your biggest risk component and attack that one first,” he recommended. He went on to match possible reinsurance solutions with the selected components: loss portfolio transfers and an adverse development cover for the reserve component; quota share or aggregate stop loss for the premium risk component; and traditional cat reinsurance for the catastrophe component.

In the example he presented at the CAS meeting, a combination of three different treaties worked to reduce all three components.

Separately, a week after the CAS meeting, AM Best published a report with results of the rating agency’s own COVID stress test, finding that the insurance industry overall—across all sectors, including P/C, life and health—remains well capitalized, with a median BCAR score of 49 percent at year-end 2019 falling to 43 percent after assumed COVID stresses. For just North American P/C insurers, the median BCAR estimates were 53 percent pre-COVID and 50 percent after stresses that included an assumed 35 percent market value drop in equity holdings and a five-point increase in loss ratios for some commercial lines.

BCAR levels of 25 percent or greater at the 99.6 percent VaR confidence level are considered the strongest levels by AM Best.

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