In a difficult times, they say, cash is king. COVID-19 has certainly brought an immediate cash and liquidity crunch to many business sectors, who have seen their income streams dramatically dry up.
But could this, over time, begin to apply to insurers too?
Historically, liquidity is a problem the sector has never seriously had to deal with. The very basis of the insurance business model - take in premiums upfront, invest and grow the proceeds, pay out later if needed - means that cash is nearly always on hand.
Within the financial services industry, it is insurers' banking cousins who need to worry most about liquidity given customers' ability to withdraw funds en masse and create a proverbial 'run on the bank.'
This is certainly true in normal times. But one thing we know for sure right now is that we are not living in normal times. The COVID-19 situation is throwing up unprecedented challenges to societies, economies and businesses, with the exit strategy to stabilization and recovery still unclear.
Perhaps, therefore, at a time when the norms have been so overthrown, it shouldn't be a surprise if the view put forward is that the COVID-19 situation could begin to create liquidity strains even for insurers. As a result, cash management will likely be an issue that the sector should start thinking hard about and acting upon right away.
Simultaneous pressure on three fronts
Standing back a little and surveying the landscape, it's likely that insurers are experiencing a number of asset, liability and investment pressures. It's that these are all happening together at the same time that makes this period extraordinary - and potentially increasingly difficult - for the sector.
On the asset or inflow side: New business is trending downward in most products and markets, with both retail and commercial customers looking to cut back on spend. Meanwhile many brokers are struggling to operate in these disrupted times and are bringing through considerably fewer new business proposals. On existing policies, some customers (both commercial and retail) have cancelled them or just not paid their premiums. Commercial renewals in particular may have been delayed. At the same time, insurers have given payment holidays and rebates for some products (notably motor) in some markets, amounting potentially to hundreds of millions of dollars.
On the liability or outflow side: Payouts are undoubtedly set to rise, and perhaps significantly. In many ways, we are sitting in the calm before the storm at present. It is still unclear how much the situation could eventually cost. But payouts for the tragic deaths that have occurred, as well as for health claims, mental health and many kinds of non-life cover will grow. This is before we even mention the elephant in the room which is business interruption cover. Some states in the US, and even national governments, have been pushing for policies to retroactively pay out to businesses even though pandemics were specifically excluded.1 But leaving that aside, business interruption will still prove a major cost to insurers. In the UK, for example, the Association of British Insurers (ABI) recently estimated that the crisis will cost £1.2bn to the UK insurance sector, with £900m of that being business interruption payouts.2 Other outflows are arising such as the US allowing early withdrawals from certain retirement funds and annuities, without penalties applied. Still, other jurisdictions like Australia are seeing lower contributions and increased withdrawals from their superannuation funds.
In the wake of COVID-19, we can also expect to see not only increasing claims but also increasing litigation over payout disputes. These could be long, drawn out and costly. Even where an insurer wins a dispute, the loss adjustment expenses could be considerable.
Meanwhile, insurers continue to have significant fixed outlays in terms of staff compensation and payroll costs. To date, the sector has not made any large-scale redundancies and some have publicly stated their intention to avoid layoffs at this time.
On the investment side: the ultra-low interest rate environment that we now find ourselves in will dampen investment returns, which may also be hit by the ongoing volatility in the financial markets. Many US insurers, for example, have large holdings in commercial mortgages and mortgage-backed securities, as well as in real estate, and cash inflows from these will be significantly down. At the same time, there are potentially dramatic increases in derivative collateral requirements which could decrease cash flow. Insurers may also experience dividend income reduction for some of the assets in their portfolios.
Clearly, the combined effects of these three pressures could be significant and are likely to grow over time. It is certainly true that the insurance industry is well-capitalized and well-diversified - but no one should be taking anything for granted. In most industries, there are early warning indicators about possible liquidity difficulties which are usually debt covenant related. But in the insurance sector, early warnings will be harder to see - making it all the more important to introduce the right cash management and forecasting tools.
Insurers taking prudent steps
Looking at the actions insurers have taken to date since the COVID-19 situation really took hold, insurers have indeed been taking some significant steps already. These include debt and capital raises (e.g., bond issuances), as well as the cancellation of dividend payouts from operating companies to parent companies or external shareholders and halting plans for stock buybacks. In some cases, these cancellations have been in response to directions from regulators - but in truth they may have been cancelled anyway. Insurers are also generally reducing their discretionary spend in order to conserve more cash, while in some markets there have been early signs of some players considering or moving to dispose of non-core assets.
These are all prudent and sensible measures - but there is much more that carriers could be doing. The real challenge here is that, for the reasons already outlined, cash management has never been a specific area of concern within the insurance sector. One could almost say that it has suffered from years of neglect, compared to other sectors which have experienced liquidity crunches in the past and have therefore developed better systems and processes to manage it. Many players simply lack the processes and indeed the cash-conscious culture in such a way that they can respond quickly to changing circumstances.
The problem of 'trapped cash'
One of the critically important issues in managing cash, especially in a complex multi-national group, is dealing with the potential for trapped cash. Put simply, this arises when cash resides in an operating company in one jurisdiction - but that cash is needed in another jurisdiction or at parent level. It can in fact be difficult to get that cash out of one jurisdiction and into another due to tax regulations, regulatory requirements (to comply with capital regimes for example) or the fact that the operating company in one jurisdiction is a different legal entity to the operating company in another.
Where an organization has a trapped cash problem, its apparent cash position could falsely appear to be much stronger than it actually is. People like to think that cash is fungible, but that's not the case when it comes to separate legal entities, due to tax law and regulatory regimes. So, establishing how much cash is sitting in the business, where exactly it resides, and how easily it can be moved if needed, is imperative.
Taking a cross-organizational, structured approach
Managing liquidity and cash flow is something that the Treasury function in an insurer should take a central role in - but bringing in all parts of the organization that are involved in cash inflows or outflows such as claims, reinsurance, sales, and operations. It is only by creating a cross-organizational approach that liquidity can be effectively managed. Cultural factors within an organization play a large part in creating and reinforcing a more cash consciousness culture. To be really effective, awareness of the importance of managing cash needs to emanate from the top; buy-in at a senior level is key.
There are many strands to managing liquidity including:
- mapping cash cycles and creating a robust forecasting process owned by all parts of the business
- monitoring and updating those forecasts at the group and individual country level, including identification of trapped/static cash balances
- performing stress testing and scenario analyses on liquidity
- developing early warning indicators on in-house liquidity and market conditions (economic, regulatory and governmental developments) with established trigger mechanisms
- validating and updating governance mechanisms around cash and ensuring that there are clear authorities in place
- developing daily key liquidity metrics or internal KPIs, along with the ability to rapidly analyze client/customer behavior at segment level
- updating modeling inputs to reflect the dramatic differences caused by COVID-19
- evaluating potential debt/capital issuances
Introducing systematic measures like these are not something that can happen overnight. It takes time and, with time of the essence right now, insurers should be acting immediately where appropriate.
Mapping and managing cash cycles
In addition, there are some more tactical areas that insurers should be examining closely. One of these is the better management of receivables. Now is surely a good time to ensure greater efficiency around collections. There should be a review of service level agreements with the insurer's intermediaries, monitoring compliance to ensure that cash held is paid over within agreed terms.
Further, it is important to ensure that the true cash position is understood relative to broker business. Many insurers have not properly mapped the cash cycle for broker business in terms of receipt of premiums and payment of commission, and so do not know where they are at any given moment within that cycle. At the present time, it is important that they do so.
Another - internal - area to review is the relationship between claims and reinsurance. Is there room to improve communication between the claims and reinsurance teams to reduce lags in billing reinsurance and also to improve the quality of information sent to reinsurers, thereby reducing queries and increasing the speed of payment?
Uncertainty in the road ahead
These are challenging times for whole swathes of the global economy. For insurers, this means a tighter approach to cash management is most likely needed. How badly they may be squeezed over the coming months remains to be seen, but the combination of the pressures we have outlined could place some strain on more thinly capitalized players or those heavily concentrated in certain lines of business. The business interruption situation is a real wild card at the moment. Regulatory or legislative action to enforce cover that simply has not been priced in could create a real risk of insurance insolvencies. This remains an important topic being hotly debated and discussed in several countries around the world.
Insurers need to focus on liquidity and cash management in a way they have never needed to do before; making cash a top priority now and into the future will be critical. This will bring challenges and a learning curve of its own; but applying a cash lens to all key decisions will support both the preservation of funds in the short term and the generation of additional funds to support complex transformation and growth programs in the new reality. Retaining a much stronger grip on liquidity will enable insurers to respond more quickly to the ever-changing conditions.
Robert J. Ceske, Principal, Insurance Risk, KPMG in the US
Barry Gale, Partner, Insurance Solutions, KPMG in the UK
Bartosz Piwcewicz, Director, Audit Assurance Risk KPMG Australia
- McCarter & English, “NJ, NY, OH, and MA Consider Legislation Clarifying That Business Interruption Coverage Applies to COVID-19 Claims”, April 1, 2020.
- Covid-19: Payouts of over £1.2 billion likely to be made to customers according to latest estimate from the ABI. (n.d.). Retrieved from Association of British Insurers.