The Covid-19 crisis is unprecedented in the modern era. It is at such times that we tend to take stock and think differently about the world. One important point of reflection is the role that insurance markets have played and should play in managing such crises.
To date, we have read stories about insurers and customers arguing over the ambiguity of policy wording. That has now culminated in the FCA going to court to seek urgent clarity. Equally, we have seen many other businesses holding policies that clearly provide no cover for a pandemic. Taken in the round, the general sentiment seems to be that the industry could have done better. To that end, efforts are under way to recommend improvements. A recently convened industry group led by Stephen Catlin is one such initiative.
Through these efforts a consensus will need to be reached about the role that the insurance industry can play in managing future pandemic risks. To do so, it is important to unpack the extent to which the industry can act alone and, if it can’t, what its part could be alongside government.
The discussion so far suggests that the industry, by itself, will not be able to adequately address future pandemic risks. Given the scale of the economic shock we are witnessing, that is perhaps no great surprise. Nonetheless, speaking as an economist, it is helpful to probe exactly why this is the case and whether there are market failures that inherently limit the capacity of the sector to act alone. In that spirit, a few starting hypotheses:
Hypothesis 1: pandemics represent such large risks that the insurance market cannot provide capacity to fully insure them. Companies have shut down for months on end, leading to large individual claims for business interruption. Compounding the damage, entire swathes of the economy have put up the shutters all at the same time. The capacity of insurance markets is large but is unlikely ever to be sufficient to absorb by itself the large simultaneous losses that governments are currently incurring.
Hypothesis 2: even if insurance exists, there may be a sizeable gap in the provision of cover to SMEs as a result of possible behaviour-related market failures. For example, future pandemic cover will add costs to policies that many price-conscious SMEs may choose not to take out. Others may underestimate the risks they face and opt against cover, especially as the memory of the crisis fades. Moral hazard, the belief that government will provide support in a future crisis, may deter others. These potential market failures may leave some of the most vulnerable (but nonetheless important) businesses exposed to future economic shocks.
Exploring these and other examples of market failure helps to diagnose the problem and find the right solutions. They suggest that the insurance industry alone cannot deal with future pandemic risks. Government may be the only actor with the balance sheet to step in during a crisis like Covid-19 and ensure adequate cover across the economy.
If this analysis is right, does it mean there is no role for the insurance industry? Perhaps not. There are several ways in which the industry can work with government to deliver a better response.
First, insurance provides a model to allow governments to defray in advance some of the huge costs of a pandemic. The UK’s government-backed Pool Re terrorism re-insurance scheme serves as a pertinent example, illustrating how a buffer can be created between taxpayers and insurance risks.
Second, insurance offers an alternative mechanism to deliver more equitable social outcomes. Higher taxes or public spending cuts are blunt instruments to pay down the costs of a pandemic. An insurance model, through higher premiums after a crisis, provides a more nuanced way of distributing at least some of the costs incurred by government; risk-reflective premiums could be adjusted by sector to reflect the degree of state support each received during the pandemic.
Third, government has not found it easy to design and distribute support quickly to those hit by the pandemic. The insurance industry provides a ready mechanism to help businesses across the country, including some of the smallest. This could well prove to be an efficient channel in a future crisis.
COVID-19 looks to have exposed some significant shortcomings in the current set-up of pandemic insurance. Improvements are likely to require a role for government and may need us to rethink how we manage catastrophic risk. Doing that effectively demands a clear diagnosis of the problems we have faced and, in turn, of the respective roles that government and the insurance industry can play. Some initial ideas have been set out, but much more work needs to be done to reach clear conclusions.
This article was also featured in the Insurance Post.