This article by David Rains was originally published by BRINK on March 11, 2020.
The most timely opportunity to take action on pandemic risk insurance is not necessarily when a new virus is making international headlines. But the spread of the novel coronavirus (COVID-19) has compelled insurers and reinsurers to take a deeper look at their potential exposures, as warning signs flash that the coronavirus may develop into a global pandemic with impacts across a broad swath of sectors.
It has been nearly three months since the first case of the virus was diagnosed outside of China (in Thailand), and the total number of confirmed cases has reached 118,101, with 4,262 total deaths, as of March 10.
The response from governments and businesses has been swift; international borders have been closed, supply chains have been interrupted and millions of people are currently under quarantine in an attempt to slow down or contain transmission of the virus.
As was the case with Ebola and H1N1, medical, life and short-term disability insurance inquiries have risen, as have the more complex, but equally valid, pandemic-related risks associated with workers’ compensation, business interruption, travel insurance and contingency.
Interest in pandemics typically comes in waves, and COVID-19 presents a situation for the insurance industry to support businesses that are in need of solutions to manage pandemic risk. However, there are a number of roadblocks that often prevent the creation of products to protect these businesses.
Concentration of Risk
The existing concentration of pandemic risk for life and health (re)insurers is one such obstacle. Knowledgeable risk-takers have already acquired a wide variety of the target risk, and insurers looking to lay off this risk often find that counterparties have similar issues. While reinsurers are comfortable accumulating pandemic risk as part of their business model, these additional exposures compound their most negative loss scenarios. AM Best analysts recently noted that reinsurers are subject to higher levels of coronavirus-related risk compared to primary life and health insurers.
Risk-takers seek to build a diverse portfolio of subject business as a hedge against mortality and/or morbidity trend changes, or temporary spikes in segments or classes of risk. As pandemic scenarios become increasingly dire, impacts are felt across a wider range of demographic groups and geographies, and while results will not be uniform across all (re)insurers, the benefits of diversification can be dramatically reduced, thwarting potential risk-transfer opportunities.
Concentration of risk and reduced portfolio diversification place considerable pricing pressure on pandemic premiums, and as a result, the risk is usually priced at a significant multiple of the modeled risk in (re)insurance, depending on how out-of-the-money the coverage attaches. Pricing will include a minimum level needed to pay for allocated capital and risk capacity, regardless of how remote the attachment may be.
Coverage for pandemic catastrophe should be considered during quiet periods, and long-term purchases will create options and market goodwill as the risk periodically increases.
In many cases, pricing may best be estimated as a fixed margin over the modeled loss. For example, if the modeled loss in two risk tranches were 50 basis points and 150 basis points, a fixed margin of 300 basis points would generate pricing at 350 basis points and 450 basis points, respectively.
Pricing responds very quickly to current risk perceptions — when pandemic conditions seem calm, a pricing margin might be 200 basis points, and when they are roiling, it could be 500 basis points or more.
Shared View of Risk
To conduct a deal, both parties must come to the table with an actionable perspective on the values and utility they are trading. These cannot be identical, or the need for a trade would be eliminated, but they also cannot be wildly disparate, which would indicate there is not enough credibility around either party’s beliefs to engage in a high-stakes transaction.
There also are not enough historical precedents to build credible loss curves for coronavirus, but some approaches look at the 1918 influenza pandemic (Spanish flu) as a “worst case” pandemic scenario and attempt to account for changes in population health, accessibility of care and modern vaccines. More sophisticated approaches leverage stochastic models that are based in epidemiological science. These models are built from the ground up using a wide range of inputs, such as a disease’s transmissibility, lethality and point of origin, as well as if there is currently a vaccine in production. Regardless of approach, there is not yet a widely accepted risk model all parties may comfortably use as a pricing basis.
Time to Negotiate
Reinsurers and insurers both come to the table with layers of stakeholders who need to agree on terms. Together, they must develop an actionable view of the risk at hand and propagate that view through their respective organizations — examples include education on the nature of pandemics, the usefulness of epidemiological risk models and the presence of any clash risks. And when one considers the layers of authorization required in the context of this rapidly evolving risk landscape, it is easy to envision iterations of approval that become invalidated each time the pandemic risk hits new milestones or spikes in the news cycle, chasing the bid/ask spread on pandemic cover ever higher. Rapid execution is critical in evolving situations, but most risk-takers are built for an execution speed of weeks rather than days.
Timing/Liquidity and Basis Risk
When considering a pandemic cover, it is important to understand how the cover should respond and when, relative to loss, recoveries should be expected. Early parametric pandemic mortality covers were written to respond to multi-country mortality rates with significant measurement lag, and in some cases, claims would not have been calculated until two years after the event began. Obviously, these structures would not be effective in providing liquidity during peak needs. Another concern with indexed coverages is basis risk: whether the triggered calculated recovery will sufficiently match the loss. This can be greatly improved with more bespoke parameters and eliminated with indemnity covers. The individualized nature of many pandemic reinsurance contracts can be a double-edged sword; however, they are difficult to finalize in a timely manner, which works against the quick-acting nature of pandemics.
Many life and health insurers have to take into consideration the enormous potential risk exposures related to far-tail disaster scenarios, such as the 1918 Spanish flu, which infected 500 million people worldwide and killed approximately 40 million-50 million people. Medical coverage carries a practical limit that governs how much capacity the health care system can deploy, but life risks are limited only by the size of an insurer’s portfolio, which is generally in the billions of dollars. Against this risk, buying only a few hundred million dollars of cover can seem like just a drop in the bucket. Still, the vast majority of pandemic events will impact the industry heterogeneously, and buyable limits will help mitigate impacts on earnings and capital.
The potential impacts from pandemic risk and the available mitigation options are something every insurance risk-taker should consider. Available structures have matured and now provide improved solutions to issues surrounding liquidity and basis risk. However, just as one cannot buy flood insurance during a storm, coverage for pandemic catastrophe should be considered during quiet periods, and long-term purchases will create options and market goodwill as the risk periodically increases. Insurance companies that do buy coverage will have it if they need it and, just as they would advise their policyholders, be glad if they never do need it.