Challenges on the Horizon

Challenges on the Horizon

The insurance industry is set to face several daunting challenges in the months and years ahead, creating new risk and opportunity for insurers. We take a look at some of the most important themes facing the industry and companies that may benefit.

by Doug Morrow

Associate Director, Thematic Research

Tightening regulatory environment

Regulations such as the Solvency II Directive in Europe and the Global Systemically Important Insurers (G-SII) initiative will impose a range of new governance, reporting and capital reserve requirements on affected companies.

The Solvency II Directive is scheduled to come into effect on 1 January 2016, and many of Europe’s 3,500 insurers are scrambling to get their finances in order. The Directive has certainly attracted criticism, not least for the administrative burden it has placed on insurers, but in our view it will ultimately help protect policyholders.

The nine companies identified as G-SIIs will have to meet higher loss absorbency standards. The market is closely following these developments, but it is still too early to judge the financial impacts, particularly since the absorbency standards will not take effect until 2019. We expect that G-SIIs with a healthy balance sheet, such as Aviva and Generali, will be best positioned to implement new capital buffers.

Climate change

Weather-related loss events are trending upward. According to Munich Re, a total of 979 weather-related loss events were recorded in 2014, up from 353 in 1980. The insured losses from these events have been substantial, with annual losses over the past 10 years averaging $190bn.

Risk from climate change impacts is ultimately borne by reinsurance companies, including Swiss Re and Munich Re. This is because property and casualty insurers have opted in large part to hedge their exposure to weather-related losses through reinsurance.

However, weather risk is also being securitised through catastrophe bonds. Catastrophe bonds are issued by insurance companies and bought by investors, including pension funds. If no catastrophe occurs, investors get their principal back. If a qualifying catastrophe occurs, investors can lose all of their principal. The market for catastrophe bonds is currently valued at $20bn, but we think it will grow significantly, partly because we (unfortunately) expect an upward trend in high-impact weather events such as hurricanes, and partly because catastrophe bonds have some attractive financial characteristics (such as low correlation with other asset classes). While we expect the market to grow, we also believe that securitisation may be exposing the capital markets to complex weather risks that may not be fully understood. The next Hurricane Katrina is likely to test the mettle of investors that have effectively bet against climate change, at least over the short run.

Insurers are increasingly using big data tools to price risk and develop products. The benefits for insurers are potentially ground-breaking. In an example that will likely be replicated, John Hancock Financial, a subsidiary of Manulife Financial, recently began providing policyholders with free fitness bands to monitor their health progress. By voluntarily sharing the results, policyholders can earn discounts of 5–15%. In another example, auto insurers are increasingly using vehicle monitoring devices to track the driving habits of their policyholders. These devices measure factors such as mileage, acceleration and braking. The number of car insurance policies that use monitoring devices is expected to reach 7 million in both Europe and North America this year.Big data

While concerns about the role of big data in the industry have been raised, we think the market is underestimating the risks. In our view, the importance of data privacy and data security is growing in lockstep with the rise of big data itself, and it is only a matter of time before the insurance industry is hit with a major breach, as Costco, Anthem and the US Office of Personnel Management have recently experienced. Ironically, some insurers are likely to benefit from this trend. The market for cyber insurance is quickly growing, with estimated global premiums in 2014 of $2.4bn. Leading providers include Marsh & McLennan, Travelers and AXA.

Conclusion

Tightening regulations, climate change and big data are likely to provide a stern test for insurers in the months and years ahead. Looking at companies through an ESG lens can help investors identify those companies that are best positioned to mitigate the risks and capitalise on the opportunities.

This article appeared in the debut issue of Responsible Investor's ESG Magazine and was republished for the November 2015 edition of Sustainalytics Reporter.