Insurance Industry Trends and Outlook

Could this business cause the next economic crisis?

Insurance Agent Explaining an Insurance Policy Contract to a Customer
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The U.S. insurance industry employed 2.7 million people in 2018. In 2017, it was valued at $1.2 trillion. Of these total premiums paid, 52% was on life insurance and 48% was on property/casualty insurance. Property/casualty includes auto, home, and commercial insurance, totalling $558.2 billion in the same year. While health insurance is measured separately, the total insurance industry contributed $602.7 billion—about 3.1%—to the nation's gross domestic product in 2017.

While these facts and figures demonstrate how large the insurance industry truly is, it’s important to understand how it has affected the U.S. economy in the past before being able to determine how it will impact the economy's future. With a potential recession looming over the U.S. economy, here’s what to know about the history, trends, and outlook for the insurance industry.

Insurance and Reinsurance

First and foremost, insurance is an agreement between you and a business to cover your financial risk. The company will pay your expenses if you experience an unlikely, but damaging or expensive, event. You may have to pay a deductible and other costs, and you pay the insurer a premium each month for this service. The insurer makes money even if the event doesn't occur.

Examples of such expensive and rare events are damage from automobile accidents, theft, home fires, flooding, and other disasters, as well as health risks.

Reinsurance is insurance for insurance providers. International companies provide insurance for local insurance firms. Reinsurance lowers risk by transferring it to global companies large enough to absorb big losses. But there is a weakness in the reinsurance market that increases systemic risk. The industry is very concentrated, spanning just 22 companies. In 2017, its premiums accounted for 90% of the total. The top company, Munich Re, made up 14% alone. If these reinsurers didn't have enough cash on hand to pay claims on a very expensive disaster, the contagion would spread to a global level.

In an attempt to avoid this, these insurers share their risk in a process called retrocession. A reinsurer like Munich Re will take out an insurance policy against its risk from another reinsurer. In this case, Munich Re is the retroceding agency and the company selling it the insurance is the retrocessionaire.

According to a 2016 Bank of Canada study, this arrangement creates systemic risk. Each reinsurer knows only its own piece of the puzzle. None is aware of the big picture of how much risk is in the entire system. As a result, it's possible that one small set of reinsurers could have too much exposure to a single catastrophe.

A big enough event could devastate this small circle of reinsurers, leading to a reinsurance spiral. Insurance could become unaffordable or even restricted, and that could affect the general economy. Without insurance, businesses would have to put projects on hold, while investors in insurance companies would have to take huge losses as stock prices fell. Large institutional investors like pensions, banks, and retirement funds would be the hardest hit.

The Insurance Industry and 2008 Financial Crisis

In 2008, the federal government was forced to spend $182 billion to bail out insurance company American International Group (AIG). The company was so large that its bankruptcy would have threatened the entire global economy. Financial institutions around the world were major holders of AIG's debt and a large number of mutual funds owned AIG stock. The $3.6 trillion money market fund industry, at the time, invested in both AIG debt and securities.

AIG is one of the world's largest insurers. Most of its business is general life, auto, home, business, and travel insurance. It also sells retirement products like fixed and variable annuities. 

So how did an ultra-safe insurance company become one of the largest bailouts in the 2008 financial crisis? AIG sold insurance called credit default swaps against losses in corporate debt and mortgages. If AIG defaulted on these swaps, it would devastate the financial institutions that owned them.

AIG's swaps on subprime mortgages pushed the otherwise profitable company to the brink of bankruptcy. As the mortgages tied to the swaps fell into default, AIG was forced to raise millions in capital. As stockholders got wind of the situation, they sold their shares, making it even more difficult for AIG to cover the swaps.

Even though AIG had more than enough assets to cover the swaps, it couldn't sell them before the swaps came due. That left it without the cash to pay the insurance. 

Could Insurance Cause the Next Financial Crisis?

The crisis with AIG reveals the critical role the insurance industry plays in the economy. Although AIG's solvency has returned, new weaknesses have occurred in the market. The industry is vulnerable to the catastrophic damage caused by extreme weather. This damage is increasing rapidly due to climate change caused by global warming. The United Nations refugee agency found that the number of natural disasters has doubled in the last 20 years. Surveys even show that actuaries believe that climate change is the top emerging risk to the industry. If it becomes an even bigger risk, there’s the chance the effects could trickle down to our wallets.

According to Munich Re’s chief climatologist, Ernst Rauch, in an interview with The Guardian, premiums could rise if companies need to adjust their risk based on climate change and its effects. “Affordability is so critical [because] some people on low and average incomes in some regions will no longer be able to buy insurance,” Rauch told The Guardian. And that could pose a large financial issue to many in areas prone to natural disasters.

The fourth-costliest year for natural disasters in history was 2018. Economic impact from natural disaster damage topped $160 billion, according to Munich RE. The worst damage reportedly came from U.S. hurricanes Michael and Florence and Asian typhoons Jebi, Signal 10 Mangkhut, and Trami. They cost $57 billion, of which $29 billion was insured. In addition, California wildfires cost $24 billion, with insured losses of $18 billion. 

The 2017 natural disaster season was worse. It broke records by costing the U.S. economy almost $319 billion. That year, 16 events cost more than $1 billion each. The chart below illustrates the overall cost of various natural disasters, beginning in 1980 and going up until 2019.

Both 2017 and 2018 ended above the inflation-adjusted overall loss average of $140 billion and $41 billion in insured losses. 

The 2016 Bank of Canada study showed that damage valued at over $1 trillion could threaten the reinsurance industry. If losses approached $5 trillion, the entire industry would be wiped out. In the future, reinsurers could go bankrupt if they don’t have enough cash on hand to pay claims. 

If the retrocessionaire group was small enough, they could all go bankrupt. Like the AIG crisis, that would devastate shareholders and their equity assets.

But how likely is that level of damage to occur? According to Florida International University finance professor Shahid Hamid in a Vice Media interview, it would be possible if a Category 5 hurricane hit southern Florida, headed inland, and then up the east coast. It could devastate Miami, Fort Lauderdale, Palm Beach, Melbourne, Jacksonville, and Orlando. Miami Beach alone could lose $6.4 trillion in real estate from now through 2045.

In 2017, it seemed as if exactly that would happen when Hurricane Irma headed toward Miami. It was the most powerful Atlantic hurricane in recorded history. Irma and Hurricane Maria were both Category 5 storms that hit the U.S. mainland in the same year. Hurricane Harvey devastated Houston in August 2017, costing $125 billion. Fortunately, Irma veered north before it hit Miami and other heavily populated Florida cities.

Irma's total cost was $50 billion when adjusted for inflation. If it had squarely hit Miami when it was still a Category 5, the damage would have been in the hundreds of billions. That includes economic impact as well as property damage. Florida's Miami-Dade, Monroe, and Broward counties' building codes have the nation's highest wind standards. But in 2017, Keith Wolfe, president of U.S. property and casualty for Swiss Re, told The Miami Herald that “there’s no structure in Miami that’s built to withstand 185 mph winds.”

To make matters worse, Florida has subsidized its insurance market. That makes the state liable for hurricane damage costs. If insurers can’t cover claims, the state itself could go bankrupt and the federal government would have to pick up the tab.

In 2019, property data provider CoreLogic said in a report that the year’s hurricanes threatened 7.3 million homes. Reconstruction costs would be almost $1.8 trillion. The greatest risk of storm surge is seen in New York City and Miami, the firm said. Potential damage to the New York City area is estimated at $330 billion, which is almost double the estimated potential cost of $166 billion to Miami.

Outlook for the Future

Hurricane damage has already sent insurance prices higher in Florida. It's become the highest-cost state for homeowners insurance. In 2016, Floridians paid an average of $3,575 a year on policies worth $200,000 with a $1,000 deductible. That's more than double the national average.

At some point, insurance companies may opt out of a market that's ultimately too risky. That would leave homeowners and developers in that market holding the bag. Without insurance, homeowners might foreclose if they can’t afford to repair the damage. A real estate market crash in the area—and perhaps beyond—would not be far behind.