Mind the gap: brokers eye fresh avenues for innovation

Climate may be the obvious “protection gap”, but Bermuda’s re/insurers have many more options they could tap into, including terrorism, cyber, pandemic disease, pensions, debt, unfunded cat, supply chain issues, and intellectual property, according to a panel discussion between five brokers at the Bermuda Risk Summit.

They were Rob Bredahl, chief executive officer of TigerRisk; Jonathan Clark, managing director of Guy Carpenter; Clark Hontz, president and partner of Acrisure Re; Paul Scope, chairman of Ed Broking; and Anup Seth, managing director of Aon Bermuda. The panel was moderated by Mia Finsness, managing executive for global casualty and underwriting claims at Markel.

A protection gap is the difference between insured losses and total economic losses, Bredahl said, and for cat risk over the last couple of years, the gap has been mostly climate-related. Citing research by Swiss Re, he said total insured losses last year were about $105 billion and total economic losses were $250 billion.

“There’s a $150 billion+ gap and the concern right now with climate change is that losses are trending up and pretty dramatically. At the same time, it’s more difficult for reinsurers and insurers to price the risk. So, in all likelihood, that gap’s going widen,” he said. Clark noted that re/insurers in Bermuda had paid out $5.5 trillion to US, UK and EU partners over the past 40 years. In that time, there’s been a $4 trillion loss from protection gap situations, he said. Three-quarters of that comes from climate change. “So the opportunity for our industry to lean into this space is immense,” he said.

“Most of the dollars on protection gaps are falling to government, which have had an over-reliance on debt financing, so the gaps are predominantly on the back of taxpayers.

“It’s an opportune time to have some more meaningful conversations about how to strike the right balance and, from there, build some solutions so we can generate business opportunities for our industry.”

Hontz added that climate change is affecting not only the profit side of re/insurance, but every element of the industry. The only thing that can alter that is “more prevalent and more detailed” data to be able to determine the risks that are insurable and those that are uninsurable.

When the risks are uninsurable, other products, such as parametric transactions, “can step into that shoe if it satisfies the client’s needs”.

Climate and its effects

The protection gap in climate risk was about 60 percent last year, Seth said, but the protection gap purely driven by natural disasters is even higher.

“There’s no arguing the fact that climate change—causing the planet to get warmer and creating more moisture in the atmosphere—is leading to extreme weather events. In the last five years, the insured loss has been well above $100 billion, but in the previous five years, the average was maybe around $60 to $65 billion. So there’s been a marked step up in the insured losses resulting from natural disasters.”

Even more worrying, he said, is the increase in frequency and severity of the “secondary” perils, which include wildfires, convective storms, flooding and tornadoes.

On top of this, the world is more interconnected than ever, which means re/insurers should not focus exclusively on the physical damage extreme weather events can cause, but also address the non-physical damage, including to supply chains and healthcare, he added. In addition, climate displacements, meaning changes to human habitats, will become more apparent as the planet gets warmer.

“These are the really important things we need to understand. And what can we do about it? Develop a framework for resilience. That means public-private collaboration, but it starts with data. How can we convert data into insights that can help us mitigate risk?,” Seth asked.

“The insurance-linked securities (ILS) sector is a great example of the collaboration in Bermuda between the regulator, the government and the industry. We already had a very strong market base here, but with the Bermuda Monetary Authority stepping in and introducing the Special Purpose Insurer licence category, and the government passing legislation around the Segregated Accounts Companies Act, the ILS industry hasn’t looked back.

“Today, that alternative source of capital represents about 15 percent of the capital in the industry, and Bermuda is the centre of that.”

ILS solution

Clark agreed that ILS offers a great opportunity because of the pool of capital available that can be unlocked, alongside traditional reinsurance, to bring solutions to bear. Through working with government, there are “ancillary benefits to bringing multiple points of risk capital for them because they lack some of the data”.

“It’s very important for public entities to be able to turn to their constituents and talk about risk. And to validate that what they’re getting, as they start to engage with the private sector, is a fair and balanced approach, from how the risk is being looked at, and also how it’s being priced,” he said.

“On the largest deals, there is already a good interaction between traditional reinsurance solutions and ILS solutions. We’re beginning to see very small steps in the terrorism area where ILS is starting to be brought to the table,” Clark said. The protection gap trend also stems from “social inflation”—the rising cost of insurance claims, Bredahl said.

“I hate that term, but in the US, we have some lousy legal domiciles—in particular, Florida and Louisiana. The trend is coming as much from social inflation as it is from climate. ILS is a good solution, but just like the traditional market, the ILS funds and pension funds are struggling to price the risk, because of the social inflation as well as the climate change,” he said.

Clark added: “These things will ebb and flow and there’s no doubt that some of those challenges are in front of us right now, but there has been tremendous movement in how analytics is helping to solve some of that. And provided it does, I think the appetite is there.”

The ILS marketplace, backed by the capital markets, is “enormous”, Hontz said, adding that more capacity and capital is traded on a daily basis in the financial institutions of the world than it is in 12 months in the insurance industry.

“The capabilities are there but I’d like to see investors move down the risk chain a bit. Investors are focused on not paying losses, or on paying losses that they are absolutely aware of. But with insurance now, and probably as climate affects everything going forward, not all losses are going to be modelled—not all losses are going to be understood to have happened at a certain time and a certain date,” he explained.

“That creates the ILS in the investor industry to move to a 1 to 4 percent probability, as opposed to how a lot of reinsurance and insurance companies protect their earnings at a much higher expected loss. I’d like to see that happen in the future.”

Seth said he would add the topic of liquidity to the debate. “There are different ILS solutions: there’s the collateralised reinsurance structure, there are sidecars, there are catastrophe bonds, and we’re clearly seeing a shift from investors towards more liquid solutions.”

Cat bond issuance last year was at a record high of over $13 billion and that trend is strong, he said. “And I don’t think we can get away without using the three-letter acronym ESG. Investors are looking for assets that are focused on sustainable investments and the ILS industry is a great opportunity to convert cat bonds into ‘green’ bonds, and attract new investors that way.”

Cat exposures

Finsness asked the panel what they thought the future looks like for the industry, in terms of being able to provide profitable re/insurance solutions to the cat exposures associated with climate change.

Hontz said statistical analysis needs to improve and not only for the main perils, but for the secondary perils that are “creating pain across the world”.

“The better the understanding of the risk, the more products will be out there and, ultimately, those products need to move with the marketplace to be profitable. Profitability means the ability to sustain risk over a period of time,” he said.

“With certain products, including California wildfires, nobody wants to write that business any more, so there isn’t an insurance solution. However, we all know, parametric wildfire analysis is in its nascent year of building, and that will continue to grow, as is analysis of hurricanes and tornado risk, in areas where homeowners can’t buy insurance if their location is within 10 miles of the ocean.

“It seems to me that there can be an alternative in a parametric windspeed transaction, for example, that allows homeowners to protect their cover. The future is full of new products, that’s for sure,” he added.

Bredahl predicted this will be “a huge season for index covers in all their forms” but, in particular, parametric coverage.

“They’ve been around for a long time, but haven’t really taken off; we think this is the year they will. This is the simple things, or bringing back old ideas, especially for lower layer cat, heavily structured multi-year quota shares, and multi-layer covers, where instead of having risk transfer you’re helping companies fund the risk,” he said.

Seth suggested that simplicity was needed to understand the exposure. “If you look at a pandemic, and how COVID-19 claims have come into the industry, that was never the underlying intention. So we’ve seen maybe some structures going back to the simplistic form of named perils only.

“Sometimes, that simplicity is innovation in a world where we can’t see the wood for the trees. We have to focus on understanding what we’re covering, understanding that exposure and, bearing in mind inflation, it’s very important the industry understands the future cost of claims.

“What is the promise to pay five years from today and how do we factor that into our underwriting? Bermuda is the centre of underwriting excellence and we need to bring that to the forefront as we face such a big challenge globally. The demand for our solutions has never been higher,” he added.

Clark turned to flood insurance in the US, saying that this is has the potential to be a $40 billion business. Technology for analytics has improved for that risk, but this information needs to be communicated better with the insured homeowners and businesses, he said. There are changes coming to the National Flood Insurance Program managed by the Federal Emergency Management Agency (FEMA), which “offer real opportunities for our business to lean in and get more involved”, he said.

No protection

Bredahl noted that five out of every six homeowners in the US do not have flood protection. “There’s a massive gap,” he said. “I live in New Jersey and when Hurricane Ida came through the East Coast, just out of curiosity I called up a handful of friends and relatives and asked: ‘Are you covered for flooding by your homeowner’s policy?’.

“Every one of them said ‘yes’. That means five out of six were wrong! I find it fascinating that smart, educated people have no idea what they’re covered, or not covered, for.”

Hontz said the fault lies with the industry, in not explaining what an insurance policy covers. “Maybe the insurance industry will look at getting in front of the risk, instead of always reacting to losses, and provide mitigation efforts: ‘If you do these things, then we will sell you an insurance policy’. I think the future of the insurance industry is linked with mitigation efforts across the board.”

Finsness agreed that this was increasingly the case in construction, where insureds need to demonstrate that their sites are secure.

“We’re seeing increased demand for loss control services from our clients, and providing that additional value-add in the insurance industry will be important in the long term,” she said.

Clark emphasised that the industry needs to focus more on pre-event mitigation, and highlighted FEMA’s Building Resilient Infrastructure and Communities (BRIC) policy. This enables FEMA to set aside 6 percent of estimated disaster expenses for each major disaster. It aims to promote a national culture of preparedness through encouraging investments to protect communities and infrastructure by increasing pre-disaster hazard mitigation and strengthening national resilience.

“As many as 40 percent of homeowners impacted by Hurricane Harvey had no insurance,” he said. “The average payout somebody with that misfortune gets from the federal government is $5,000 to $10,000 for immediate expenses. They don’t get a lot of money. Those who had insurance, however, had an average recovery of $145,000.”

He added: “There’s huge potential to get engaged if we’re going to close the protection gap. The largest share of the wallet is going to be government, so how we partner with government going forward is very important.”

Bredahl noted that the take-up rate for earthquake protection by homeowners in California is only around 12 percent. “In some cases, it’s not even required by the mortgage companies. That’s an enormous gap and reflects human nature—people like to roll the dice.”

Finsness noted how utilities were being sued for the impacts of extreme weather events. An example of this was the winter storms in Texas that led to wrongful death claims because of the failure to restore electricity supply.

“You see the claims coming in on the liability side, you see environmental social inflation trying to find a deep pocket to pay,” she said. “The industry will be paying for it one way or another and I think we’re going to see more and more of that as time goes on.”

Other gaps

Climate change isn’t the only area where there’s a perceived protection gap in the marketplace, Finsness said, and asked the panel where they see “other emerging areas of concern” in the industry.

“Protection gaps exist across everything we look at and everything we do, and that’s fundamentally what we’re in business to help solve,” Clark said.

“Our industry has already made some pretty good inroads into issues related to terrorism, and it can be argued that we have a better relationship with government in terms of providing viable solutions to commercial clients.

“Cyber is one area where our industry can rightfully say we’ve been proactive in leaning in and starting to build solutions. For example, credit risk transfer began with just a handful of reinsurers, but now they are 45 reinsurers actively involved in that area in the US.”

Although his expertise is in property treaty, Clark said it was clear to him that an ageing population made pension funds, both public and private, an increasing concern.

“A lot of stats across a lot of countries show that people simply do not have enough money for their retirement and that’s going to put massive pressure on governments everywhere,” he said.

“And the amount of debt that’s being held on balance sheets across the globe is certainly not going to get any easier. It comes back to climate in a way, where there’s unbudgeted, unplanned for, catastrophic loss, large portions of which are falling to government to fund.

“With retirement issues, debt, and unfunded cat, there’s going to be change coming to that, and it’s going to be incumbent upon our industry to become more engaged.”

There is greater recognition “across all constituents” of climate risk, and the same will come for other issues. “When there’s a balance between government, regulation and business, meaningful solutions can be brought to bear, and you’re not just constantly spinning your wheels,” he added.

Scope said he was “the odd man out” on the panel because he is more focused on insurance than reinsurance transactions, but that it was obvious Bermuda could be the centre for climate risk finance.

He pointed out another, less obvious, protection gap—that of intellectual property.

“Over 85 percent of the assets in the Fortune 1000 companies are actually not physical assets, but intellectual property, and that’s hardly insured. There’s a team at Aon leading the charge here and getting some coverage, and I’m involved with a managing general agent (MGA) that’s trying to get some intellectual property coverage.

“That’s another thing that’s probably easier to get a hold on than climate.” Another gap is in wage and hour liability insurance, he said, while the supply chain issue is a growing concern.

The beauty of the Bermuda market, Scope said, is that it is not only innovative, it is also becoming more collaborative. “We’re first for having US risk coming down here, but we’re working better nowadays with London. I think we used to see each other as competitors, even if we denied it, but now we collaborate and find solutions for the global client.”

A lack of insurance in the life and annuity space is clear in the US, Europe, the UK, “and even Asia-Pacific”, Seth said, adding that, in the UK alone, there’s more than £2 trillion ($2.6 trillion) of uninsured pension liability. These protection gaps are all worth highlighting, he said.

Bredahl argued there is “very little cyber protection provided versus the risk”. “If you can’t quantify the risk, if you can’t figure out the aggregations, it’s very difficult to price it, although I’m sure the market will eventually figure it out. Another example of where there’s a big gap is pandemic disease coverage—and for very similar reasons it’s very tough to quantify that risk.”

On protection gaps created by the pandemic, Clark said: “The risk industry absolutely has to be at the table and be part of those conversations.” Bermuda is the hub of innovation, he said. “Any transaction you can do, you can do it here, but I don’t think relying on the government to help us get from A to B is the answer. It has to be private industry that brings these new products.”

A mature Bermuda

Scope noted that the new entrants to the Bermuda market—the class of 2020—were different from the classes before them.

“Back in the 1980s, when AXA XL was set up, it was for a series of events, then there was 9/11 and Hurricane Andrew that got the property cat market going. It was our speed to market that led to billions of dollars of capital coming in.

“It created a cottage industry, but the most recent entrants are interesting, because there wasn’t one particular event that got them to come here. Instead, it was an opportunity created by a prolonged hard market,” he said.

“It’s also being driven by industry veterans, such as Stephen Catlin (Convex), Greg Hendrick and Dinos Iordanou (Vantage Risk), and Trevor Carvey (Conduit Reinsurance). That’s a sign we have a mature market, where senior people at the height of their careers are prepared to come back to Bermuda and bring their expertise.

“That’s why I’m confident we’ll solve a lot of the coverage gaps right here,” Scope said.

“Another new thing is that we’ve stopped being arrogant about MGAs. Not only are we now insuring and reinsuring MGAs, we’re providing the capacity for them. A lot of the new startups are MGAs and that’s another area I think Bermuda will prosper in.”

Bredahl added, however, that changes to taxation are reducing the advantage of working in Bermuda. There is no income tax, but there is payroll tax, which means the companies that can fare best in Bermuda are those with “big balance sheets and relatively few people”, which are the reinsurance companies, he said.

“In 2018, the US lowered the marginal effective tax rate, which diminished the relative advantage of being in Bermuda,” he said. “To continue to have a real marketplace with innovation and talent, means that pressuring the government to make it a very good place to do business is pretty high right now. Having said that, tax rates in the US will definitely swing back.”

Clark recalled a conversation he’d had with representatives from the US Senate Finance Committee. “The topic turned to reinsurance and a senator said: ‘That’s one of the reasons God invented Bermuda’. It’s obviously a great place, with the appropriate mix of government, regulation and international business.

“By the same token, we all know how competitive it is out there and that things are moving very quickly. How do you keep your eye on the ball and keep moving forward?”

Hontz said Bermuda was the only place where you can “visit 20, 30, 40 risk-takers in a single week”. “It’s expanding and the talent pool is enormous. As for the tax part, I think there’ll be an equilibrium somewhere and the marketplace will overcome the tax issues because more and more people will come here to do business.”

Scope added: “On the insurance side, it’s always been the regulation that’s driven business here, as opposed to the 50 countries that make up the US. People are coming here now for the maturation of the market.”

“The advantage of doing business in Bermuda is that it’s such an efficient place to bring risk and capital together,” Seth said. “At Aon, we’re helping our clients across the spectrum, whether it’s large corporates for whom we’re positioning their captives as the underwriter of choice as the markets harden; optimising balance sheets for commercial reinsurance companies; getting more capacity from the direct market of the reinsurance market and retro market; the ILS industry; or the legacy market that’s also flourishing. I’m very bullish on the Bermuda market.”

On how the industry could innovate, Seth referred to the cost of capital. “We realise as an industry that the equity or the permanent capital we have within certain balance sheets, that risk reward, may not be conducive to the returns that the permanent capital is looking for.

“Can we get alternative sources of capital? Can we go to third-party capital vehicles? Perhaps that’s a better source of capital for this risk-reward ratio. That’s an evolution we’re seeing but it will accelerate as we move into this next phase of innovation,” he concluded.