Paul Carroll, the editor-in-chief at Insurance Thought Leadership, recently sat down with Michel Léonard, the chief economist and data scientist at the Insurance Information Institute. They discussed the state of the global economy, geopolitical risks, and their potential impact on the insurance industry.
What follows is a transcript of that conversation, edited for length and clarity.
Paul Carroll
There’s certainly a lot to think about. Where should we start?
Dr. Michel Leonard
The global economy is facing a complex set of challenges that are likely to have significant implications for the insurance industry. Inflationary pressures, geopolitical tensions, and the continuing effects of the pandemic are creating a high degree of uncertainty and volatility in financial markets.
In this environment, insurers will need to be particularly vigilant about managing their risks and maintaining adequate reserves. They may also face increased claims activity in certain lines of business, such as business interruption and event cancellation insurance.
At the same time, the current economic conditions could create opportunities for insurers that are well-positioned to navigate the challenges. For example, rising interest rates could boost investment returns, while a heightened focus on risk management could drive demand for certain types of coverage.
Overall, the insurance industry will need to remain adaptable and proactive in responding to the evolving economic landscape. By staying attuned to the latest developments and adjusting their strategies accordingly, insurers can position themselves for success in the face of uncertainty.
Paul Carroll
This report is a bit different, focusing on potential problems and geopolitical risk scenarios, rather than the specifics of economic conditions.
Dr. Michel Leonard
In our recent economic discussions, we've been covering a lot of topics such as growth at the GDP level for both the country and the P&C industry, as well as inflation and replacement costs. Throughout these conversations, I've consistently mentioned that geopolitical risk is a major caveat to growth recovery and prices returning to a more normal range.
Given the significance of geopolitical risk, I thought it would be valuable to take a step back and pay more attention to specific risk scenarios. The aim was to expand on what we have in mind when discussing these risks and how they can affect not only the economy at large but also the P&C industry specifically.
Paul Carroll
What are the key geopolitical scenarios the insurance industry should be concerned about?
Dr. Michel Leonard
We identified three key scenarios that warrant serious attention from the insurance industry: conflict in the Taiwan Strait and the South China Sea, continuing or worsening war between Russia and Ukraine in the Black Sea, and the Houthis’ attacks off the coast of Yemen.
Let’s take those one by one. Taiwan is a real concern, but it has not yet degenerated into armed conflict. For immediate impact on the P&C industry, we are focusing on existing conflicts, first the war between Ukraine and Russia and second the Houthis’ attacks off the coast of Yemen.
We identified three key scenarios that are already unfolding and warrant serious attention from the insurance industry: the conflict in the Taiwan Strait, issues in the South China Sea, and the continuing situations with Russia and the Houthis.
While the U.S. security apparatus has contingency plans for potential escalations in Taiwan and the South China Sea, the current conversation suggests that strategic nuclear weapons may be the only way for the U.S. to uphold its commitment to protecting Taiwan against the PRC. If such a scenario unfolds, we would face far greater challenges beyond just economic concerns.
By focusing on the conflicts with Russia and the Houthis, we can bypass the need to convince people of their plausibility and instead concentrate on how they directly affect us. Both situations are significantly affecting two out of the three major international shipping routes in and out of the Mediterranean Sea: the first by disrupting Black Sea shipping through the Turkish Straits, and the second by disrupting shipping off the coast of Yemen and the Gulf of Aden leading to the Suez Canal.
As a result, to determine the impact of both conflicts on any industry and the P&C industry in particular, it becomes crucial to examine what goods are being transported through these shipping routes, their origins, and their destinations to understand the full implications for the insurance industry and the global economy.
Paul Carroll
What are the potential impacts on various insurance categories if conflicts escalate in the Turkish Straits or the Strait of Gibraltar or with the Houthis off the coast of Yemen?
Dr. Michel Leonard
The Turkish Straits and the Strait of Gibraltar are two of the three key entry and exit points in the Mediterranean Sea. If conflicts were to escalate in these regions, it could have significant implications for the insurance industry.
The Turkish Straits, consisting of the Bosphorus and the Dardanelles, are particularly critical. Any disruption in this area would likely prompt the government, security apparatus, and Department of Defense to plan for contingencies. While there are currently only minor skirmishes and no continuing conflicts, the situation warrants close monitoring.
It's important to assess how different categories of insurance might be affected under these scenarios. The potential impacts could vary depending on the specific line of business and the extent of the conflict. For the P&C industry, shipping disruptions in the Turkish Straits ultimately lead to increased replacement costs for commercial property, and disruptions by the Houthis off the coast of Yemen increase replacement costs for homeowners insurance content.
Paul Carroll
What is the impact of the conflict in Ukraine on global food supply and prices, particularly in relation to the disruption of grain shipments through the Turkish Straits?
Dr. Michel Leonard
The conflict in Ukraine has significantly disrupted the export of grain and concrete bonding agents from the country's Black Sea ports. Out of Ukraine's five main ports, only one or two are fully operational, and even then, peaceful transit through the Black Sea is not guaranteed.
This food supply disruption has far-reaching consequences for the rest of the world, leading to food scarcity and famines in many regions. While the U.S. is relatively fortunate in that food is still available, albeit at higher prices, many other countries face a more dire situation.
The impact of the disrupted grain shipments from Ukraine is particularly severe in Central American countries like Guatemala and Nicaragua, contributing to increased immigration and refugees seeking to enter the U.S. from the Southern border. These grain shipments, which would typically pass through the Turkish Straits and the Strait of Gibraltar to reach the East Coast of the U.S., particularly the Port of New York and New Jersey, have been significantly affected.
As a result, food prices have increased, and the cost of bonding agents used in construction has also risen, which has implications for the insurance industry.
Paul Carroll
What are the main impacts of the disruptions?
Dr. Michel Leonard
The disruptions in the shipping routes are affecting the property and casualty insurance industry in two primary ways. First, in the Black Sea and Turkish Straits, the disruption in the supply of concrete bonding agent is directly affecting commercial construction, as concrete is a crucial material in this sector. This is causing issues with both price, availability, and quality.
Second, the disruption of shipping routes through the Gulf of Aden and the Suez Canal is affecting the supply of consumer goods, particularly those from countries such as Thailand, Indonesia, Malaysia, Pakistan, Bangladesh, and India. These goods, which include textiles, garments, and some furniture, are commonly used in homeowners' content. As a result, this disruption is affecting the cost and availability of replacement goods for homeowners' insurance.
In terms of the magnitude of these impacts, our stress tests estimated that P&C replacement costs across all lines could increase by an average of around 7 percent for the affected goods, with a range of up to 3 percent in the best-case scenario and up to 12 percent in the worst-case scenario.
It's important to note that, unlike during the pandemic, the current disruptions are not significantly affecting the supply of automobiles or consumer electronics, as these goods typically come through different routes or directly from other regions.
Paul Carroll
What are you finding as you talk to insurance executives about your geopolitical risk scenarios? Are they buying into the exercise and prepared, or might they be caught by surprise?
Dr. Michel Leonard
It's important to distinguish between headlines risk and business risk when discussing geopolitical issues with insurance executives. While topics like political unrest, civil wars, and terrorism generate interest, they don't always directly translate to operational impacts for insurers.
To establish credibility, we focus on specific, actionable information. For example, in our Taiwan Black Sea or Yemen scenario analysis, we concentrated on identifying major shipping routes, goods exported and imported, and primary ports of entry into the United States. By moving away from the headlines and drilling down to operational specifics, we gain credibility and engage in more productive conversations.
Just recently, I had a conversation with a senior insurance executive who initially questioned our focus on Taiwan. After I explained our approach and provided specific details, the conversation shifted to actionable insights. We discussed potential changes in homeowners’ insurance, such as the allocation of coverage between content and structure, and how the industry can prepare and educate consumers in light of these trends.
Paul Carroll
What are your thoughts on the state of the commercial real estate market? Do you believe more clarity is emerging, particularly regarding interest rates, office space usage, and potential conversions to residential properties? How might these factors affect insurance companies as investors and underwriters?
Dr. Michel Leonard
The level of uncertainty in the commercial real estate market remains the same as a few months ago, but we do have a better sense of direction. The recovery for commercial real estate will likely involve transferring these properties to residential commercial, with large landlords managing the properties. The coverage of these properties by commercial property carriers will depend on how they define their business. We are closely monitoring this trend, which has yet to begin in earnest.
The trigger for this trend was always the Federal Reserve cutting or reducing interest rates and adopting a more dovish stance, which it has done. However, the current market conditions and unemployment levels are, in our opinion, a consequence of the Fed waiting too long by about six months. While we don't anticipate a recession, economists were surprised by the recent numbers, as they crossed thresholds that call for different monetary policy reassessments.
We don't expect the Fed to accelerate its original easing plan, but it is a prerequisite for any revival or recovery in both commercial and residential housing. Good news in either sector, including the conversions we discussed, is needed.
Regarding unemployment, my current expectation is that the decrease in interest rates and the market's expectation of continued Fed action will inject life into residential real estate. Any resulting bump in construction employment should help bring overall unemployment back from the concerning levels economists are currently observing.
Paul Carroll
Enlightening as always. I always feel smarter after we talk.
