Long Read

Running for Cover: Insurance and Covid-19

The Olympics, Wimbledon, The British Open. Just a few in a long list of global sporting events that have been postponed indefinitely or cancelled due to the global outbreak of Covid-19. The impact on athletes, coaches, staff and even spectators has been significant. Furthermore, this pandemic has led to devastating losses for the various financial stakeholders of these events, such as sponsors and organisers. However, some organisations have been more financially protected than others and will breathe a huge sigh of relief. Wimbledon, for example, has been paying nearly US$2 million annually after the 2003 Sars outbreak in order to include pandemic coverage in its insurance policy. The tennis tournament’s organisers – The All England Lawn Tennis Club (AELTC) – are set to receive a pay-out of US$142 million, highlighting the importance of having the foresight to buy an insurance policy that covers black swan events. While there is presently a large buzz around the consequences cancelled fixtures will have on organisers and the sports themselves, there will also be a long-term impact on the insurance market.

Insurance isn’t a modern concept. Historians date insurance back to 4000 BC in Babylon, with the establishment of ‘bottomry’ contracts – provisions granted to merchants stating that loans did not have to be repaid if goods were lost at sea. Policy types continued to expand with major events causing the creation of new insurance categories. For instance, the Great Fire of London in 1666 brought about the creation of fire insurance while the San Francisco earthquake in 1906 accelerated the growth of life insurance policies. The twentieth century has seen a rapid evolution in the development and sale of insurance policies ranging from life, health, property, travel, accident, crop and livestock, and more. Essentially, if there is any foreseeable risk associated with an event or activity, there is a demand for insurance.

At a basic level, insurance is relatively easy to understand. Put simply, insurance is protection from potential future loss. When a consumer buys insurance from a company, they pay a premium to the firm which ‘underwrites’ the risk of the adverse event. This essentially promises monetary protection in case the event occurs.

Insurance companies have multiple revenue streams. The most crucial one is receiving premiums on insurance policies. The premium is not a “one size fits all” amount – insurance companies use sophisticated mathematical models along with a large database of information to determine the probability of any given event and a resulting premium is applied. Imperfect information or misjudgements could lead to massive losses for the firm. If the premium is set too high, the firm risks pricing out the least risky consumers who are least likely to claim a pay-out. On the other hand, if the premium is set too low it may not be enough to cover a potential pay-out. In economics, one learns that the first rule of any business is to maximise profits. Insurance firms are exactly the same – their goal is to optimise premium pricing so that the overall revenues are greater than their potential pay-out expenditure.

Another revenue stream for insurers is investing the ‘float’ (premiums received) into a portfolio. Firms usually tend to invest their funds in stable, short-term liquid assets to protect and gain additional investment on their capital. Government bonds, which are known for their safety, are a common investment option for insurance firms.

Re-insurance is an additional and important step in the process for insurance firms. This involves buying insurance on the insurance policies that the firm has sold to consumers. Complicated? Hopefully this example helps: assume a firm sold a large number of earthquake insurance policies in an extremely low-risk area. Due to the low-risk nature of the area and the corresponding low premiums, if an earthquake did occur in the location, the firm would be faced with a massive pay-out and incur significant losses. Re-insurance helps the firm redirect some of the responsibility so that they do not have to pay the entire amount and risk going under. This is crucial in the insurance sector as it protects businesses from defaulting on policies and leaving consumers in financial danger, while also reducing the prospect of massive profit and loss fluctuations for the firms themselves. Diversification of risk is crucial to the long-term sustainability of the insurance sector and reinsurance requirements are regulated.

From a consumer standpoint, adequate insurance cover is seen as a necessity. However, as always, the devil is in the details. After the 2003 Sars crisis many insurance firms excluded pandemic coverage in their overall insurance package. Therefore, for a company to be protected from a pandemic they would have to pay an additional premium. Many individuals and firms viewed a pandemic as a black swan event and decided that protection against an event with minimal probability was not worth the additional expense.

Covid-19 has exposed legal and ethical issues related to insurance. Several policies did not include pandemics – but the disruption to businesses, livelihoods and health has been enormous. For individuals and businesses that have been paying a premium for years the news that their revenue and income damages are not covered due to the pandemic is devastating. John Neal, Chief Executive Officer (CEO) of Lloyd’s of London, has said that the Covid-19 pandemic could be the most expensive event in history for the insurance industry. With business interruption remaining a big concern, there is a growing pressure on governments to force insurers to retroactively cover Covid-19 losses.

First, firms will be met with General Insurance claims – non-life insurance. As mentioned before, pandemic coverages have generally been excluded from this type of insurance and should make managing claims easier. Travel insurance claims are likely only to be met if the consumer had contracted the virus right before or during the trip, but not for general cancellation – the exact specifics vary from firm to firm. Business insurance, which again doesn’t include pandemics, mostly results in pay-outs if there has been a physical loss to the firm’s resources. Despite this insurers are going to face government pressure and may find themselves exposed in a drawn-out legal battle. However, there are two other areas where insurers are likely to be seriously impacted: event insurance and trade credit insurance.

Event insurance will be more reasonable to manage as many organisations did not have the foresight that Wimbledon had to purchase pandemic insurance. However, some other major events like the Olympics had full cover insurance packages. It is estimated that the postponement of the Olympics and the resulting insurance claims will equate to nearly US$2 billion of coverage. This is clearly a heavy blow to insurance firms and with more fixtures being postponed it will be interesting to see how firms deal with these claims. Re-insurers are also likely to face heavy losses here. Munich RE Group, a re-insurance firm, could have US$500 million worth of exposure if more events are cancelled.

Trade credit insurance protects suppliers from outstanding debts held by consumers. As a recent KPMG report highlighted, trade credit insurance is a US$11 billion market and insurers are likely to experience multiple issues when facing claims. As more and more businesses start closing or defaulting on payments due to the sudden decrease in demand, insurers will be faced with large pay-outs.

Secondly, life insurers will face an increasing number of claims. Insurers will be faced with increased payouts although the extent to which this will affect life insurers will be interesting to see in the long-run. Covid-19 has highlighted the inequality present in our societies all over the world and it is the lower-income population who are least likely to spend a fixed monthly amount on insurance. Therefore, the effect on the life insurance sector is likely to be manageable. The increase in deaths over the past few months due to COVID-19 will have some impact on these firms but it is the turbulent financial markets that will cause the biggest headaches for both general and life insurers.

We have established that reinvesting in government bonds and financial markets is a crucial part of an insurance firms’ revenue stream. Therefore, the economic downturns and decrease in asset values are bound to hurt insurers significantly. The aforementioned KPMG report also states that “life insurers manage more than US$20 trillion in assets and as much as half of this is estimated to be in government bonds.” The value of the US treasury bond has seen a sharp decline recently and both the 1-month and 3-month bills entered negative yield rates around a month ago. Furthermore, the 10-year treasury bill has fallen from a 2.50% yield rate at this time last year to 0.69% right now. Put simply, insurance firms invest both in short-term and long-term bonds as they are considered a safer investment than equities. Floating rate bond notes (FRN) are a substantial proportion of the US government’s long-term bond market. These are bonds where as interest rates change bond yields change as well. This is a significant issue for insurers with FRN’s because central banks have slashed interest rates globally. Furthermore, many insurers hold short-term bonds, which will be affected due to the reinvestment risk because of the lower interest rate environment.

However, there are many positive long-term effects for insurers. In most cases, insurers have a constant flow of revenue from premiums every month. It is unlikely that current consumers who already have insurance packages will stop their policies. Therefore insurers have a steady flow of money coming into the firm. In fact, at the end of the crisis, insurance firms are likely to see a sharp rise in demand for health and life insurance, as was seen at the end of the Sars crisis. This is especially relevant in most emerging economies where health services are privatised.

Covid-19 is likely to result in a significant increase of people taking out pandemic coverages and change the minds of those who believed that Sars was a once in a lifetime event. Furthermore, there are bound to be increases in people taking out ‘any cause’ coverage for travel and business related reasons and pandemic coverage for event insurance packages is expected to see a sharp rise as well. Overall, these events show consumers the need to be financially secure and insurance firms are bound to benefit from this change in consumer behaviour. It seems as though firms may benefit at the end of this pandemic as we’ll all be running for cover.

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