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The Insurance Protection Gap: What is it and how does it affect the insurance industry and our quality of life?

The insurance and reinsurance industries are challenged to decrease the Insurance Protection Gap in order to ensure economic growth and financial wellbeing on a global level. Capacity from the ILS market can help achieve that with the expansion into non-CAT risks

April 29, 2021
Insurance protection gap, financial wellbeing, insurtech, reinsurtech, ILS, insurance
The Insurance Protection Gap and how to decrease it

Originally published in Insurtech Insights:

The insurance industry has been developing fast in the past few years. Companies have been focused on growth and increasing their Gross Written Premiums (GWP), but are facing increasing challenges such as tough competition, a low interest rate environment, growing customer expectations and regulatory scrutiny.

New Insurtech players are entering the market, offering innovative services and cutting edge digital tools in order to overcome these challenges. These new tools and services fall into three main categories:

  • An easy, intuitive and user-friendly purchase process from the initial offering until a purchase is made, moving away from the way insurance products were sold in the past.
  • Digitalization of services and policy management throughout the product life cycle, including claim payments. Emphasis on immediate and efficient digital services and meeting customer demands.
  • Development of new insurance products which are adapted to recent technological developments and the evolving needs of the digital world.

These innovative services have radically increased activity in the consumer arena, comprised of private persons, businesses and large companies. This arena consists of a large number of mostly small and local arenas which mostly manage their distribution locally.

In order to be able to fully fulfil insurance obligations towards consumers, insurance companies must receive capacity from the reinsurance arena. The reinsurance arena is extended and global, and provides sophisticated partial or full transfer of insurance risks. Reinsurance transactions cover a wide range of risks in varied financial structures, allowing insurers to develop business strategies and structure capital in accordance to those strategies.

The Insurance Protection Gap (IPG) measures the difference between optimal insurance coverage and actual coverage in every country. In other words, the protection gap describes uninsured losses in any given country. This gap is naturally dynamic and affected by many factors, such as economic strength, changes in GDP and population, as well as risks such as climate change, cyber, pandemics or technological and behavioural developments.

The IPG can also be applied to the reinsurance arena, describing the difference between the demand for reinsurance capital and the actual supply of it. This is partly due to the reinsurance arena being very centralized and comprised of a handful of very large companies that take insurance risks onto their balance sheet. They simply lack the capacity to be able to meet the immense market needs, leaving trillions in unfunded liabilities in the consumer arena. Furthermore, reinsurers are facing the same challenges that their clients are, leading to a further decrease in available reinsurance capacity.

The more activity there is in the consumer arena with innovative new products, the bigger the reinsurance protection gap becomes. This has severe repercussions: a country’s ability to reach financial stability and growth, as well as improve the quality of life of its citizens, depends on the IPG. Therefore, increasing the flow of capacity from the reinsurance arena to the consumer arena is necessary to ensure future growth.

One way to increase the flow of capacity from the reinsurance arena to the consumer arena is to introduce innovative and creative solutions, similarly to what is currently happening in the consumer arena, opening up new opportunities in the reinsurance market.

The Insurance-Linked Securities (ILS) market, which has been growing steadily in the past decade, is doing precisely that. ILS solutions translate actuarial risk to financial risk through the capital markets, transferring that risk from cedents (insurers, reinsurers, pension providers and more) to capital market players such as institutional investors and banks.

ILS solutions are flexible, can cover multiple years, have high capacity and fast time to market. Cedents that transfer risk using ILS benefit from immediate capital and regulatory relief.

While ILS solutions originally covered mostly catastrophe risks, they have since expanded into the Life and P&C insurance markets, covering short and long tail risks which were considered difficult to cover, such as:

  • Mortality and longevity risks
  • Motor liabilities
  • Stop loss or excess of loss transactions for top layers of reinsurance towers
  • Reverse mortgage portfolios
  • Lapse risk
  • Other P&C liabilities such as general liabilities, property risk, worker compensation, professional liabilities and more

Cedents which transfer their risk to the capital markets also benefit from regulatory arbitrage which lowers transaction costs. While the insurance and reinsurance markets are under the same regulatory framework – Solvency II, capital market players have little or no regulatory capital limitations, and banks that are under a different regulatory framework – Basel 3. For example, under the Basel 3 framework, credit risk is considered the main counterparty risk, therefore insurance risk is a welcome diversification point, lowering pricing for the cedent transferring the risk.

Cedents that take advantage of the benefits ILS have to offer will be able to optimize their risk management and structure capital in a way that will go hand in hand with their business strategy.

ILS market growth will not only benefit cedents – increased capacity in the reinsurance market will help decrease the Insurance Protection Gap, ensuring economic growth and financial well being on the local and global level. Expanding the ILS market into other non-CAT risks is a critical step in achieving this expansion and providing sorely needed capacity to the insurance and reinsurance markets.

Watch market leaders Citi, Guy Carpenter and Vesttoo discuss the expansion of the ILS market in the virtual ILS NYC 2021 conference by Artemis here.