COVID-19’s impact on commercial insurance

Intro:
Welcome to CPA Australia's COVIDChat. A weekly podcast to answer your questions about the latest news and developments impacting business.

Dr Jane Rennie:
Hello, I'm Dr. Jane Rennie, General Manager, external affairs at CPA Australia. It's Monday the 29th of November and you are listening to COVIDChat, bringing you this week's need to know information for business and accounting professionals. Today, we're going to discuss how the pandemic has changed the face of the insurance market with a focus on commercial insurance. Joining me to provide an expert perspective is Tony Jackson from QBE insurance group. QBE is an Australian based global general insurance and reinsurance group.

Dr Jane Rennie:
And Tony is the longtime head of investor relations at QBE, and has been an industry insider for many years before that.He's also an accountant like so many of our audience members. Welcome Tony and thanks for sharing your insights with us and our audience today. It's a big question to start off with, but can you paint a picture for our listeners of the impact of COVID on Australia's commercial insurance sector?

Tony Jackson:
Sure, Jane. It's certainly been an interesting 18 months since the beginning of the pandemic. COVID just had a number of direct and indirect impacts on the commercial insurance sector. And the obvious direct impact has been substantial claims costs spanning multiple classes of business. And I'll just quickly run through those areas that have been affected. Business interruption, which attaches to a lot of property insurance and especially small business package insurance. And no doubt, we'll be talking a bit about that later. Event cancellation. And if you think about the insured cost of cancelling the Tokyo Olympics last year, and the number of business conventions, music festivals, et cetera, that have been cancelled as a result of COVID.

Tony Jackson:
Travel insurance is another one which not only incurred a substantial amount of trip cancellation claims costs but actually lost all of their premium income base because travel ceased all together. Then there's liability insurance. And so think about corporates being sued for not handling some aspect of COVID risk mitigation properly like quarantine hotels, or security companies that were involved in quarantining. And then workers' compensation, where you may have heard there are people who caught COVID at work such as first responders and essential services workers.

Tony Jackson:
It wasn't all bad news though. There were some classes of business that actually benefited from lower claims costs associated with reduced business activity and the obvious ones, motor insurance, both commercial and retail, and just think about your own personal travel and staying at home. So there was a reduction in traffic accidents, which was beneficial in terms of claims costs. But at the outset of the pandemic, the industry expected very substantial claims in classes of business that were sensitive to economic conditions.

Tony Jackson:
And there were two in particular, trade credit insurance, which insures customers receivables against default. So effectively against your customer becoming insolvent and not paying you. And mortgage insurance, which protects banks against mortgage default including unpaid interest and any short or between the proceeds on the sale of a property and the value of the loan. And those two classes of business, trade credit and mortgage insurance, QBE writes both those classes of business.

Tony Jackson:
And in April last year, we stated publicly as part of a capital raising that we could incur claims costs of as much as 300 million U.S. across those two classes, just depending on how badly the economy was impacted by COVID. But fortunately, a combination of aggressive and coordinated monetary and fiscal policy and a softening of insolvency rules kept cash flowing through businesses, it softened the impact of COVID on employment and underpinned the local housing market. So that dire scenario, that economic scenario I painted for trade credit insurance and mortgage insurance never actually eventuated.

Tony Jackson:
On business interruption, it's a really interesting area. The industry was not expecting business interruption to respond to the pandemic for a couple of reasons. Firstly, the insurance industry just simply can't afford to underwrite a systemic risk that could impact every single policy holder at the same time. And so, policy wordings included clauses and various triggers to exclude pandemic risk. So at the outset of the pandemic the industry did not expect claims in the business interruption space, but it's a complex area and uncertainty as to exactly how policy wordings should be interpreted gave rise to industry test cases that you may have heard or read about.

Tony Jackson:
And right now the industry and policy holders are waiting to hear the outcome of an appeal that was heard a couple of weeks ago by the full federal court and which should provide greater clarity around how business interruption policies may or may not respond to COVID. So watch this space. It'll be interesting to see how it evolves. There could be some claims payable by the industry and we'll see how that appeal comes out.

Tony Jackson:
But one of the most significant and often overlooked indirect impacts of COVID on the insurance industry has been the impact of nearly zero interest rates on insurers' investment earnings. So property and casualty insurers make money via two sources, underwriting profits, which is the difference between the premium and the claims and administrative costs they pay out, and then there's the interest carried on the premium. So, insurers receive the premium and they put it in the bank and they earn interest on that until the claim is paid, which in some commercial classes of business can be many years later.

Tony Jackson:
And so to counter the economic impact of the pandemic, central banks all over the world drove interest rates to virtually zero and certainly in the case of Australia. But in some cases in Europe, interest rates are below zero. And that's taken an enormous amount of earnings away from the property and casualty industry. And so, to counter that impact, insurers need to increase their underwriting profits. And along with recently adverse catastrophe experience, which no doubt you want to talk to me about, Jane, lower interest rates has contributed significantly to higher premium rates.

Dr Jane Rennie:
That's an absolutely fascinating description, Tony, and I guess what I'm wondering, you've mentioned Australia and you've mentioned Europe, to what extent has the Australian experience been comparable to what has happened globally?

Tony Jackson:
Sure. Look, obviously the pandemic was global or is global, but the degree of incidents of the virus vary significantly by country. And some countries were hit a lot harder than others. And Australia was one of the lucky countries, I suppose, by virtue of being an island and a long way from everywhere, but also as a result of the federal government's early decision to close the border. So we had nothing like the incidence of viruses, say, the UK or the U.S. nor was the virus anywhere near as widespread across Australia as it was in most other countries.

Tony Jackson:
So relative to many other parts of the world, Australia got away with a relatively modest lockdown or a related disruption. And with the exception of perhaps Melbourne and to a lesser degree, Sydney, a lot of the country didn't experience some significant virus outbreaks, and a lot of the country didn't really experience a huge amount of lockdown related disruption.

Tony Jackson:
So, the related impacts or COVID related impacts on the Australian commercial insurance industry that I was talking about earlier, those classes of business that were affected, most of those impacts also occurred on a global basis. With the exception of probably business interruption, which really only impacted Australia and the UK. And I'll just delve into that and give you a little bit of an insight why that is. Most insurance market in the world either do not sell non physical damage business interruption insurance.

Tony Jackson:
So in other words, your business interruption only pays out if your property plant or equipment is physically damaged by, say, a fire or a storm. In Australia and the UK, policy wordings had this concept of non-physical damage. And in a lot of part of the world, the policies included very strict virus exclusions as well. So the U.S. is a good example where QBE has major operations. Policies in the U.S. do not respond to non-physical damage. And almost all of the policies across the industry also include strict virus exclusions.

Tony Jackson:
So business interruption claims costs in the U.S. are likely to be minimal. You may have read or seen reference to a number of court cases with major restaurant chains that have tried to sue insurance companies claiming that their property is actually physically damaged by COVID. But in almost all instances, those court cases were found in favour of the insurers. In the UK, the industry had complex and arguably outdated business interruption policy wordings, and those policies were pretty old fashioned and they were intended to protect against localised diseases like foot and mouth or cholera.

Tony Jackson:
Although designed to protect against localised business closure due to, say, gas leaks or bomb threats. They weren't designed to protect against a global pandemic. But despite the intention of the policy wordings, following a number of the test cases that took place in the UK not unlike the test cases that recently took place in Australia, many of the policy wordings in the UK were found to respond to COVID. And so, the UK insurance industry is in the process of paying a substantial amount of COVID related business interruption claims. But for all the other classes of business that I mentioned, event cancellation, travel insurance, et cetera, et cetera, you had a similar impact across the globe. And of course, interest rates globally have fallen to virtually zero.

Dr Jane Rennie:
So, Tony, thinking about the smaller end of the business sector, and I'm thinking our SMEs, how does it match up what the insurance industry was expecting to happen over the past 18 months and what has actually transpired?

Tony Jackson:
Sure. Well, at the onset of the pandemic, and I'm really talking about March, April last year, and with no certainty around a vaccine being developed at all let alone in a reasonable time horizon, it was not difficult to envisage a fairly drastic economic downturn. And I'm talking about quite a deep recession, very significant increase in unemployment, falling residential property prices. And as a consequence, collapse in consumer confidence and spending. And you put all of that together and that amounts to a significant increase in small business insolvencies.

Tony Jackson:
So faced with that sort of economic scenario and the uncertainty around business interruption wording that I mentioned a moment ago, the insurance industry was quite concerned about the potential for very significant business interruption related claims costs. Some segments or sectors of the economy are far more sensitive to lockdown than others. And if you think about it, sectors like airlines, anything travel related, gymnasiums, hospitality, businesses that require foot traffic for sales, they are very sensitive to lockdown and were more impacted than, say, sectors of the economy if you look at the other end of the spectrum like, white collar workers in the finance industry.

Tony Jackson:
I work in insurance and all of QBEs staff were able to work remotely and effectively to this day. So when you think about that spectrum of the segments that were exposed, there are some segments clearly that were much more adversely impacted from a profitability perspective. And then you need to think about it geographically. I mentioned earlier, Melbourne, was hard hit and the worst hit across Australia. And so, Melbourne CBD in terms of a geographic location was most hard hit of any locale in Australia, followed by Sydney CBD, and to a much lesser degree, the other capital cities. And the more regional you go, the less the lockdown.

Tony Jackson:
So you can put it into that perspective and then get a feel for the potential impact. The impact, I guess, overall though, was on the small business community was notwithstanding that backdrop or that potential backdrop, the impact on the small business community turned out to be less severe than originally anticipated. And that's partly because that dire economic picture that I painted earlier did not eventuate as a consequence of fiscal and monetary policies stimulus, but also in particular job keeper and the adaptability of the small business community.

Tony Jackson:
If you think about small business, their two biggest costs are payroll and rent. And JobKeeper took a lot of their payroll pain off them. And a lot of property owners gave small business rent relief. And then, think about the adaptability of the small business community. After a couple of lockdowns, the small business community started to realise that there were ways of pivoting their business to deal with lockdowns. And the best example I can give you are restaurants, where restaurants pivoted to takeaway food rather than in restaurant dining. Think about gymnasiums, where they were hosting fitness sessions in local parks where you're only allowed two or three people. So, if you think about over the last 18 months, look at some of the insolvency statistics, the level of insolvency amongst the small business community was much, much lower than anyone envisaged.

Dr Jane Rennie:
The event sector was, of course, another sector that was very, very significantly affected by lockdowns. And just last week, I read that the Victorian and New South Wales governments are set to introduce a government backed insurance scheme to assist with the staging of events. I'm also aware that the government has begun offering a reinsurance pool to reduce premiums in Far North Queensland. I was wondering, what are some of the consequences when the government steps into the insurance sector like this?

Tony Jackson:
Sure. Look, in some instances you get a situation arise where it's just not feasible for the insurance industry to offer cover. And the event cancellation situation over the last 18 months has cost the global insurance industry, many, many billions of dollars. And I mentioned the cancellation of the Tokyo Olympics as a perfect example. I'm not sure of the exact specifics of that proposed scheme. I was aware that a lot of people involved in trying to host events has been lobbying the government because insurance is at the moment not available.

Tony Jackson:
You only have to think about the panic generated by the Omicron variant, just over the last week to understand the limited appetite for insurers to offer event cancellation right at this moment. And equally, if you think about travel insurance, I haven't contemplated travelling yet, but I'm not entirely sure what your travel insurance policy will offer you in terms of both protection from a health perspective, and also covering costs if you are stuck in an overseas location because you test positive to COVID just prior to getting on a plane to come home.

Tony Jackson:
So it is quite logical that the industry's reluctant to offer event insurance. And when it's not offered, then the government does have to make a decision whether they get involved and to what extent they get involved. In terms of Far North Queensland, insurance pricing there has been an area of political pressure for many years with numerous reviews having been undertaken. And all of those reviews concluded that despite the very high premium rates that are being charged for home insurance and property insurance more generally relative to the rest of Australia, insurers were not making excess returns.

Tony Jackson:
And it's probably not surprising given just how prone Far North Queensland is to cyclones and flooding and given the concentration of population living on the coast and on coastal flood plains. So, affordability has become a big issue and the federal government has stepped in to try to create a government backed reinsurance pool. I believe it's about $10 billion, the intended size. And the purpose of that is to help subsidise the cost of insurance coverage for cyclone and flood for individuals and small businesses.

Tony Jackson:
I don't think the details of the scheme have been finalised yet nor how it might respond or adapt to further population growth in the region, because one of the unintended consequences might be that the subsidy encourages more people to move to Far North Queensland. So, it will be important for the government to simultaneously implement other longer term risk mitigation strategies, such as stronger building codes using different building materials for properties to be able to withstand stronger winds, and also focus on flood mitigation and stricter planning guidelines.

Dr Jane Rennie:
Can you tell our listeners a bit about what's happening now with insurance premiums and what are the elements underlying this?

Tony Jackson:
Sure. We are now a couple of years into a global upswing in premium pricing that really started in earnest in around the back end of 2018. And it's been driven by a number of factors, including firstly, fundamentally poor industry returns. And the industry's profitability was allowed to deteriorate for many years prior to the upswing in pricing where rates were either flat or negative, but they were certainly less than claims inflation. And the industry's long term underlining return on equity just wasn't good enough.

Tony Jackson:
And you also had many years of reserve releases. So, insurers profits are in any one year a function of the business they're writing in the current year, but also a reassessment of business they've written in previous years. And for many years, the insurance industry was relying on favourable reserve releases from prior accident years. And that had been subsidising that deterioration and underlying profitability, and that level of surplus or redundant reserves has come to an end. And so that cross subsidy has come to an end. I mentioned interest rates earlier, and interest rates have been low since the GFC.

Tony Jackson:
And it took the industry many, many years to acknowledge that interest rates were not going to go back to where they were prior to the GFC. And then obviously, when COVID interest rates went from low to nothing. So low interest rates is another contributing factor. Then, of course, you've got losses directly associated with COVID that the industry needs to recoup. And I don't know where that final figure will land, but around the middle of last year, most of the industry commentators around the globe were predicting an ultimate cost to the global insurance industry in the range of $50-100 billion.

Tony Jackson:
Now, it's probably likely to be at the bottom end of that range or it could even be a bit better than the bottom end of that range because the world economically managed the COVID pandemic better than what perhaps everyone expected from the outset of the pandemic. And that was partly driven by the fact that the pharmaceutical companies came up with a vaccine that was effective and they came up with it relatively quickly. Another factor that is contributing to rising pricing is adverse catastrophe experience. And up until about 2017, there was a decade period prior to that where catastrophe experience was pretty benign.

Tony Jackson:
But from 2017 to now, you've had an elevated level of catastrophe losses. 2017 was pretty much in line with the worst year in history for the global insurance industry for insured catastrophe losses. And that experience since then, coupled with concern around global warming and whether catastrophe experience is going to deteriorate from here and how fast it is or whether we're in a short term cycle, that's creating uncertainty in the industry that the global insurance industry is acutely aware of and looking to make sure that they're pricing appropriately in their product.

Tony Jackson:
Then you've got uncertainty around inflation. And this is an interesting one. And you would've read a lot about the spike in inflation around the globe, and whether it's transitory and a function of supply chain disruption as a result of COVID, or whether there are underlying pressures there of a return to higher fundamental inflation. And that obviously has an impact on claims costs for insurers. And right now labour costs and material costs are elevated for repairs after catastrophes, rebuilding houses and so on. And so that's having a bearing on insurers thinking around pricing.

Tony Jackson:
But there's also social inflation or judicial inflation. And that is the propensity for the court to feel sympathetic towards the customer. And you get this ever spiralling upwards claims costs. And so, globally, the world is quite unsure right now exactly what's happening from an inflationary perspective. And I think the insurance industry right now is more inclined to price assuming that this is more than just a temporary spike in inflation. And then the final point I'd add is that a lot of the factors I've just spoken about are also having a bearing on the profitability of re-insurers.

Tony Jackson:
So QBE is primarily a primary insurer. And by that, I mean, that we deal primarily with the end customer. We buy reinsurance to help protect our own balance sheet. And the big re-insurers around the world, like Munich Re, Swiss Re, their profitability is coming under pressure. And they're now starting to put their reinsurance costs up. And in response to that, primary insurers are going to have to pass that through to the consumer.

Dr Jane Rennie:
Many businesses receive direct financial assistance from the federal government, and I'm thinking JobKeeper and the cash flow boost. What's the treatment of these funds where a business, say, is making a claim for business interruption?

Tony Jackson:
Yeah. I touched on the industry test cases briefly earlier. In conjunction with the Australian Financial Complaints Authority, AFCA, the insurance industry has participated in a number of business interruption test cases over the past nine months. Those test cases were undertaken to obtain clarity on legal issues concerning the interpretation of the wordings and whether business interruption or whether business interruption policies would respond to the pandemic. But part of those test cases was to consider the impact of JobKeeper on losses to small business.

Tony Jackson:
And in October, the federal court delivered a ruling largely in favour of the insurers on many of the issues under consideration, including the treatment of JobKeeper. So the court ruled that in assessing any business interruption loss as a result of COVID-19, policy holders would have to include the benefit of JobKeeper. And given how significant payroll costs are for small businesses, JobKeeper was obviously hugely beneficial in terms of keeping businesses operating and people employed and is expected to materially reduce the severity or the size of valid business interruption claims. That second test case ruling has since been appealed. And we're awaiting on a ruling from the full federal court in December or early next year. So watch this space.

Dr Jane Rennie:
And, of course, there have been other things going on in the world while COVID's unravelling. And I'm thinking about climate change. What can you tell us about how climate change has been shaping the insurance market?

Tony Jackson:
Yeah. You probably need to dedicate a standalone session for the impact of climate change on insurers. But just briefly, climate change exposes insurance companies to numerous risks and opportunities, including physical, transitional, and liability risks and opportunities. Physical risks are the obvious area that most people focus on, being the impact of climate change on the frequency, severity, and variability of weather related catastrophes.

Tony Jackson:
And not only is the industry experiencing increased frequency and severity of catastrophes, but there's also some unusual events happening like, for example, the freeze that hit Texas in the first quarter of this year and caused the biggest insured first quarter loss for the North American insurance industry since the Northridge earthquake in 1994. Texas doesn't normally get freezing cold, but got horrendously cold temperatures and just about every water pipe in every house in Texas burst. So the cost of that event was enormous.

Tony Jackson:
So the insurance industry is investing a lot of money in catastrophe modelling to try to help identify and predict weather pattern changes serves to be able to price more accurately, but also to assist customers and the community in adapting and building resilience to the impact of climate change. And I mentioned strengthening building codes earlier, flood mitigation strategies, et cetera. Insurers typically only issue insurance policies for 12 months. So, in theory, they can keep increasing premium rates in line with the trend and catastrophe experience to maintain profitability.

Tony Jackson:
But the problem with that is that in longer term and without mitigation, you reach affordability limits as we arguably already have for Far North Queens and as I mentioned. And at that point, governments step in and the viability of the industry is threatened. The insurance industry is also exposed to transition risk from climate change being the impact of changes in policies, technology, and markets on demand for insurance products and the potential investment terms on the investment side of the business as the world transitions to a low carbon economy.

Tony Jackson:
It's not directly climate related, it's more technology related, but think about the potential impact of autonomous cars on the insurance industry. Premiums for traditional collision insurance, you'd expect to be greatly lower in an autonomous car world, but in its place, you could see huge growth in liability insurance pertaining to vehicle software and the network infrastructure that keeps cars from crashing. So insurers have to think about transition risk and where they need to be positioning their business for the longer term. And the industry also is exposed to liability risk, which is an interesting one from climate change.

Tony Jackson:
And that's the insurance industry sells liability insurance to corporates. And so what if any exposure might the industry have to legal action against corporates for their contribution to climate change? QBE has a big team of dedicated professionals focused on the impact of climate change as part of sustainability more broadly. And anyone interested I'd urge you to read the sustainability report in our 2020 annual report.

Dr Jane Rennie:
Tony, thank you so much for joining us on COVID Chat today. It's been absolutely fascinating. For our listeners, if you have a question about any of the topics we've discussed today, or any of CPA Australia's policy and advocacy work, please email us at [email protected]. If you've enjoyed what you've heard, please tune in again next week and tell your friends. From all of us here at CPA Australia, thanks for listening.

Outro:
And that's our episode for this week. Thanks for listening. To ensure you don't miss an episode, subscribe to the CPA Australia podcast channel on your favourite app. And for more COVID resources, guides, and information, visit cpaaustralia.com.au/covid.