26Sep18

SCOR Live Blog

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Will the refragmentation of the world affect insurance and reinsurance?

Political risk is blocking reinsurers' best efforts to push back the frontiers of reinsurability, says Denis Kessler, Chairman and CEO of SCOR in an article published in Reactions

A lot of the attention, effort, energy and resources deployed by the reinsurance industry over the last two years have been dedicated to dealing with issues linked to unfortunate political developments, rather than acts of God or (re)insured events in general. The long list of examples proves the point: Brexit and the spectre of the cliff edge it is raising for capital markets and financial services as a whole; the Base Erosion and Anti-Abuse Tax provision of the US tax reform, which taxes reinsurance premiums ceded to affiliated foreign subsidiaries and has obliged many global reinsurers to heavily restructure their operations; the episodic sharp increase in financial market volatility, as the recurring prospect of a Euro-sceptic party winning an election in Europe casts a shadow over the future of the Eurozone and its currency; the multiplication and continual back-and-forth of sanctions and embargoes, placing reinsurers under the unpredictable threat of a constantly moving compliance risk; the accelerating trade wars rhetoric which could set the entire economic and financial world on fire; the potential dismantlement of multilateral agreements, and so on and so forth.

 

Negative divergent forces

 

Most of these developments reflect an ongoing refragmentation of the world in all areas. This could become a serious concern for all activities that have benefitted from globalisation over the last 25 years.

 

Economic inclusion, freedom of trade, freedom of establishment, freedom to move capital and freedom to provide services create optimal business conditions for any economic sector. Conversely, economic fragmentation, regulatory and trade barriers, obstacles to trading and providing services freely and the non-fungibility of capital hamper economic activity and weigh on economic growth and the rate of innovation. These simple truths mean that all developments – be they trade policy measures, geopolitical dynamics, regulatory frameworks, or even fiscal measures – that are economically inclusive, are “constructive”, while those which contribute to economic fragmentation are “destructive”. In short, convergent forces are positive and divergent forces are negative.

 

The pendulum of globalisation seems to be slowing down and may even be starting to swing in the opposite direction

 

After more than half a century of progressive inclusion, the world today seems to be becoming increasingly fragmented. This fragmentation is pervasive: international cooperation is weakening, tensions between countries are increasing, norms are being challenged, multilateral institutions are becoming weaker, populist movements are pressuring countries over their sovereignty, etc.

 

The example of Europe says it all. The increasing opposition to the European Union (EU) is crystallizing in nearly every European country. On 29 March 2019, the UK will leave the EU, and with it the single market and the customs union. The perspective of a hard Brexit has recently returned to centre stage as the UK parliament is fiercely split over the agreement to propose to the EU. Such a divorce in Europe sets a precedent and send out a very strong political signal from what has been – historically – the country of free trade.

 

The golden age of globalisation most likely reached a tipping point with the financial crisis of 2007. Like every crisis, it ignited the flames of populism, patriotism and protectionism, on the back of strong resentment against globalisation and trade liberalisation. Since then, globalisation has been increasingly blamed for the subsequent economic turmoil and fall in people’s living standards, and for magnifying inequalities to the benefit of a privileged global elite. The crisis has hence strengthened nationalist political forces throughout the world and made states and economies increasingly inward- instead of outward-looking, with falling confidence in supranational entities and international frameworks.

 

The number of trade barriers – non-tariff restrictive trade policy measures in particular – appears to have been rising since the crisis first erupted. Protectionist measures are being advocated, and adopted, worldwide. Multilateralism is increasingly being replaced by bilateralism and the threat of a global trade war has not been this high since 1945, driven by the current US administration. Donald Trump believes that “Trade wars are good and easy to win”. The only fallacy in this argument is that trade wars are not zero-sum but negative-sum games: over the long term, everyone will lose from global economic fragmentation.

 

Today’s situation is rather an abrupt about-turn from the six-decades of economic integration since the end of World War II. This trend, associated with a global economic boom and the continuous opening up of markets, had initially – from the fifties to the eighties - been mostly restricted to developed economies, but from the nineties onwards had progressively become truly global and inclusive. These years saw significant progress in multilateral negotiations, boosting trade and further accelerating the wave of economic convergence which had already begun fifty years earlier. One year after the North American Free Trade Agreement (NAFTA) came into force between Canada, Mexico and the United States, creating a trilateral trade bloc and the largest free trade area in terms of GDP at the time, the World Trade Organization (WTO) was established in 1995. This comprehensive and ambitious intergovernmental initiative hailed the victory of multilateralism, extended trade liberalisation to all areas, including services and intellectual property, and institutionalized the principles of free trade by providing a framework for negotiating trade agreements and even a resolution process for trade-related disputes. The paroxysm of this economic convergence process was reached in the early 2000s, as China joined the WTO after 15 years of negotiations. This milestone signified China's deeper integration into the world economy.

 

The search for identity and poor public risk management

 

Is the financial crisis the only reason for this sharp U-turn? Of course not. That would be far too narrow, economic and parochial a view, ignoring the complex and abstruse dynamics at play with such developments. The reasons behind the current refragmentation of the world are manifold: the 2007 financial crisis and subsequent economic insecurity have certainly played a role, but so have the widespread crisis of representativity and the perception of being controlled from afar by an out-of-touch “elite”, feelings of inequality and insecurity, and a perceived lack of opportunity. It is the explosive combination of all these factors that is currently threatening the post-war international order.

 

Ultimately, divergence and fragmentation are first and foremost a reflection of the growing importance attached to identity throughout the world. This is the breeding ground in which protectionism, self-withdrawal, solipsism and patriotism are flourishing.

 

In the case of Europe at least, widespread defiance against Brussels is also a testimony to the massive political failure of European states and institutions to identify and manage risks, especially those related to uncontrolled mass migration, which is the common denominator underpinning all anti-European parties. This issue and the various societal and economic risks that it raises, which could have been anticipated, analysed and managed by the European authorities through both adequate preparation and mitigation, have been largely ignored for decades and are now tearing Europe apart. Just like every risk, populism can be managed, but states have proved unequal to the task. They are poor risk managers, which is incidentally more than amply demonstrated by the undue explosion of public debt in most developed economies. Due to both procrastination and short-term bias, issues and problems are never dealt with on time, if they are dealt with at all. Most risks are merely ignored and then suffered.

 

Therefore, the short-sightedness of most political institutions and their inability and unwillingness to address and manage risks are also to blame for the strong populist backlash fuelling the movement of economic fragmentation.

 

The impact of global refragmentation on insurance and reinsurance

 

When looking at the (re)insurance space more specifically, we see forces moving in two opposite directions: on one side, countries wish to maintain – or even regain – their national control and supervision of the (re)insurance sector; on the other side, there are several ongoing initiatives to build international rules and common frameworks for a global level playing field. In the latter case, a good example is the development of the ICS, which aims to define a common solvency framework for all “internationally active” insurance and reinsurance companies. We can also cite the development of IFRS 17 to adopt an accounting standard with a global perspective. In reality though, the ICS appears difficult to implement and IFRS 17 will only cover part of the world, with the US in particular not being concerned. The "covered agreement" signed one year ago by the European Union and the United States to facilitate cross-border (re)insurance business between the two is a rare example of regulatory convergence between both sides of the Atlantic.

 

Insurers and reinsurers are paying careful attention to the refragmentation of the world. And this is perfectly comprehensible. They have their finger on the economy’s pulse, on both sides of their balance sheets: in terms of exposure on the asset side as long-term institutional investors, and in terms of franchise development on the liability side, since both the expansion of the risk universe and the demand for risk coverage are fuelled by economic growth. Hence, over the long term, economic inclusion tends to structurally spur (re)insurance, whilst economic fragmentation tends to weigh on growth and therefore to stifle (re)insurance.

 

Reinsurers’ particularly high sensitivity to these issues comes from one industry-specific reason: reinsurance is by essence a genuinely global industry. This is even a key characteristic of our business model: a reinsurer’s value proposition relies on the global diversification of the risks it carries onto its balance sheet, by business line and by geographical area, to maximize its resilience to shocks and to minimize the cost of risk coverage. A reinsurer may therefore operate optimally in the long run if and only if it can build an international footprint – without friction – to serve insurers and businesses globally and hence get unhampered access to all markets, thereby pooling and mutualizing risk exposures on a worldwide basis. This does not hold for insurers, as insurance markets still remain largely national, with limited transborder transactions. Even though rules governing insurance are more and more common, the example of the EU clearly shows that national markets are still largely juxtaposed – with national insurance service providers meeting the demands of national insurance demanders. The aspiration to freedom of service for insurance actually remains marginal. Hence, while the refragmentation of the world will increase the costs of (re)insurance and therefore reduce the economic benefits it brings, it will have a rather marginal effect on insurance.

 

Micro turbulence or macro trend?

 

One may argue that several recent or current developments are heading in the right direction, so saying that the world is currently fragmenting is, from this point of view, overplayed.

 

Of course, it’s not all black and white, for the simple reason that the issue is multifaceted. In any given period, some developments, whether local, regional or international, will be convergent and inclusive, while others will be divergent. The recent trade agreement concluded between Europe and Japan, or – to quote a more specific (re)insurance development – the "covered agreement", are examples of welcome economic convergence. Notwithstanding such positive developments, from a political and economic standpoint it is obvious that the last ten years have seen a strong surge in fragmentation and divergent developments. But it is still too early to say whether we have entered a new global economic regime or whether this turbulence will calm down.

 

One may draw an analogy here with plate tectonics, which describes plate motions at the Earth’s surface. There is a wide spectrum of directions and magnitudes of motion, with both convergent and divergent plate boundaries. Furthermore, these motions are complex and constantly evolving over time. Incidentally, the global movement of tectonic plates is consistent when taking a very long-term view: over quasi-periodic cycles lasting several hundred million years, plates alternatively assemble, coalesce into one supercontinent, and then break apart as rifting makes more, smaller continents. The “economic supercontinent” of the 2000s has clearly started to break apart. The question is whether a global rifting environment will now be the new normal for a significant period of time, or whether this is just local economic seismicity.

 

The main danger is the fact that fragmentation and division are self-sustaining. As they incite retaliations, divergent developments have a natural tendency to escalate. It takes far more effort, energy and time to unite and make a system inclusive than to divide and break it apart.

 

Weathering the refragmentation of the world

The mitigation of these issues and shocks is rendered even more complex by the fact that most political developments are not foreseeable.

 

To navigate these troubled waters, modelling capabilities are virtually useless, since the fragmentation of the world is associated with the concept of uncertainty rather than risk. It seems extremely challenging – if not impossible – to model and quantify populism or poll elections, and what we can learn from past observations is extremely limited as the derivation of analytical rules on these matters remains fanciful.

 

Reinsurers must instead demonstrate ex ante general market and political sensitivity on the one hand, to avoid being utterly caught by surprise by these divergent developments, and ex post strong operational agility, flexibility and nimbleness on the other, to optimally transform and quickly adapt to the new environment whenever necessary. Managing these risks is – for once – more about art than science.

 

It would be great if the reinsurance industry could focus on risks and not be distracted by political uncertainties, but I’m afraid that’s just wishful thinking. I believe that visibility in the reinsurance industry is deteriorating, entropy is growing, and global reinsurers will have to regularly cope with such distractions and diversions – to paraphrase French philosopher Blaise Pascal – in the foreseeable future. How ironic that reinsurers are striving to push back the frontiers of (re)insurability in a world which seems to be increasingly conspiring to make risks less (re)insurable!