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April 13, 2018

Reinsurance: Dying… or in a Golden Age?

Summary:

Catastrophes have put pressure on the industry, but the changing nature of risk opens up historic opportunities.

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Much has been said about the challenges facing the reinsurance industry, to the point where the industry and a few of its major players have been characterized as being in a potentially terminal decline. However, to focus on recent results is to overlook fundamental changes in the nature of risk in the 21st century that could benefit the world’s major reinsurers, with opportunities unlike any seen before in the modern history of reinsurance.

A difficult financial backdrop for reinsurance in 2017

Financial results for major reinsurers in 2017 saw substantial contractions from prior years, driven by large catastrophe losses from hurricanes and California wildfires. These results have been followed by cost reduction in the reinsurance industry, which has elicited surprise in two conflicting ways. For some, the surprise was that the cost-reduction efforts could affect reinsurance, given that such exercises were more common for their cedent primary carrier clients. For others, the surprise was that it had taken so long for a focus on cost to come to the reinsurance market.

Concerns about the future financial performance of the reinsurance industry are held at the very highest levels of leadership among major reinsurers. In response to questions about the company’s 2017 performance, Swiss Re CEO Christian Mumenthaler commented on the state of the property catastrophe market that “we need to get used to a world where margins are much lower.” Given that property catastrophe profits have been one of the best-performing segments, not just in reinsurance,but in the entire insurance industry, according to McKinsey, this is an unwelcome development for the medium-term profitability of reinsurance firms.

Bearish commentators do not blame recent poor results on an unfortunate confluence of large-scale U.S. property losses, excess capital in the reinsurance industry or a temporary soft market. Rather, global advisory firm EY points to “clear signs that reinsurers face a long-term structural phenomenon rather than a short-term fluctuation of the insurance cycle.” EY goes on to warn in a report on the reinsurance industry that there is “compelling evidence that reinsurers are inexorably moving toward a ‘dead end’ with their legacy business models.”

The potential for reinsurance, with a longer-term lens

Such pronouncements about the potential for the reinsurance industry to perish are, however, overblown. Far from the rapidly changing risk environment undercutting the role of reinsurance, changes in the nature of risk have the potential to unlock a golden age of reinsurance where reinsurance institutions could play an even more important role in the future of the global economy than ever before. Two megatrends affecting society in the 21st century could bode very well for the reinsurance industry.

The shift from physical to non-physical assets on balance sheets

First, the emergence of non-physical assets fundamentally alters the nature of risk, which will require major changes in the P&C insurance industry.

According to Ocean Tomo, in 1975, more than 80% of the market capitalization of the S&P 500 was derived from physical assets and infrastructure. Property insurers, therefore, had a key role in insuring the most valuable assets of the business community. However, by 2015, property assets made up a relatively small share of the value of businesses, with 87% of that value being tied to intangible assets. For centuries, the P&C insurance industry was focused on the protection of property, but in the space of a generation the relative importance of physical property has declined precipitously. Risk to assets hasn’t gone away; there has just been a shift from physical to non-physical assets.

See also: The Dawn of Digital Reinsurance  

The shift toward digital risks as a driver of risk to a company’s income statement

Second, the emergence of digital risk is fundamentally changing the potential causes of loss for businesses. When you move beyond a balance sheet perspective, where physical property has declined in importance, and look at the income statements of contemporary businesses, you also see an increasing reliance on digital technologies with substantial potential for business interruption when these technologies are disrupted. These losses are already being witnessed today with the recent NotPetya attack illustrating that many major businesses can lose hundreds of millions of dollars from a single cyber event. It is, therefore, no surprise that cyber risk has skyrocketed in importance from the #15 item on the minds of risk managers in 2013 to the #2 item on the minds of risk managers in 2018, according to a report from Allianz.

What is remarkable is not just the meteoric rise in importance of cyber risk over the past five years but the fact that we are just scratching the surface of a megatrend that promises to have an even greater impact in the years to come. Changes in technology are fundamentally changing the nature of risk due to the digitization of the economy, the automation of entire industries and the explosion of Internet of the Things (IoT) devices. As the economy shifts from having 10 billion Internet of Things (IoT) devices to more than 200 billion IoT devices, sources of digital risk are set to skyrocket, along with the potential for cyber losses.

The foundation for any financial risk transfer product – where is the financial loss?

Estimating the financial impact of cyber risk is a difficult endeavor. A recent piece of research conducted by RAND, supported by the CyberCube unit of Symantec and the Hewlett Foundation, estimated that cybercrime today costs the global economy at least $275 billion to as much as several trillion dollars. When you layer on the emergence and deployment of new technologies, this number will only increase over time.

Not only will these losses due to cyber events rise, but cyber catastrophe modeling research undertaken by CyberCube suggests that there will be a shift from attritional day-to-day losses affecting individual to firms to more and more large-scale losses affecting multiple companies simultaneously from global aggregation events. Such events were once deemed somewhat theoretical, but the last 18 months have revealed a series of cyber aggregation events that have shown that cyber events have the potential to lead to simultaneous losses from many companies, and we are just at the beginning of a major technological change.

In many cases, the absolute level of risk for the global economy will decline. For example, with the emergence of new safety features in automated cars, the incidence of property and casualty losses from automobiles will decline.

However, new sources of catastrophic risk emerge as the potential arises for mass losses from the simultaneous failure of the technology affecting thousands of companies simultaneously. CyberCube has identified more than 1,000 technology “single points of failure” that could pose sources of aggregation risk to insurers, and this number will only grow as the years go by and new cloud-connected technologies are rolled out. To draw an analogy to the property insurance market, you can expect far fewer one-off damages from one-off fires burning down a single home and far more wildfires destroying entire towns.

Implications for reinsurers

So what are the implications for reinsurers?

1. The foundation for any financial risk transfer product – where is the financial loss?

Changes in the nature of company assets, technology and the emergence of connected digital risk are reducing absolute levels of risk to the society overall but concentrating the potential for financial losses in a smaller number of catastrophic events. This is precisely the type of risk and financial transfer that the reinsurance industry can provide.

2. Emerging cyber risk is so complex that the largest and most sophisticated reinsurers stand to gain the most from this shift in the risk landscape

Given that cyber risk is not geographically constrained, the ability of smaller and less sophisticated reinsurers to participate in a large number of geographically diversified natural catastrophe treaties is diminished. The nature of cyber risk is so complex and dynamic that only reinsurers with a critical mass of expertise in connected digital risk will be able to effectively understand, monitor and model cyber risk. There will be more differentiated insight in cyber risk than in natural catastrophe risk.

3. Investment from reinsurers is needed to understand cyber risk today, in advance of catastrophe events that could create tremendous financial opportunities for reinsurers in the future

It is a cliché to say that it is just a matter of “if not when” for cyber attacks on individual companies. What is becoming increasingly apparent is that the same can be said for catastrophic cyber aggregation events that cause material damage to many companies simultaneously. When this happens, insurance history suggests that demand for coverage will increase, capital will flee the market and prices will harden. The reinsurance market for cyber as a peril might be small today, but reinsurers that have taken the time to invest in their own capabilities ahead of these events, with informed capital to deploy when market demand spikes, will benefit tremendously.

See also: Mamas, Tell Your Kids to Sell Reinsurance  

Conclusion: Terminal decline or golden age?

The nature of risk is fundamentally changing, which means the nature of financial risk transfer also must change. 2017 may have been a bad year for the financial performance of the reinsurance industry, but this is a market where time horizons need to be considered over many decades and certainly not over the results from one financial year alone.

Far from the reinsurance industry being in a potentially terminal decline, changes in the nature of risk in the 21st century, stand to benefit the most sophisticated players in the reinsurance industry if they can take advantage of digital trends and understand new risk concentrations.

Reinsurers that invest in understanding the nature of cyber risk, and the sources of catastrophic losses, not only stand to benefit in outsized ways relative to other insurers, but they also stand to help society reap the tremendous rewards of new technology by mutualizing financial risk when technology inevitably goes wrong.

The reinsurance industry as a whole is neither in terminal decline nor at the beginning of a new golden age. It is the action of individual reinsurance companies, and their efforts to understand, quantify and model digital risk that forms the basis of whether they will thrive or falter in this emerging digital age.

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About the Author

Pascal Millaire is the CEO of CyberCube, a Symantec Ventures company dedicated to providing data-driven cyber underwriting and aggregation management analytics to the global insurance industry.

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