The latest Insurance Risk Monitor from Broadstone, this month focuses on the current heightened geopolitical risk environment and how insurers can navigate it.
This decade is shaping up to be unlike any other in recent memory. Just as the world began to emerge from the COVID-19 pandemic, there is now armed conflict in Europe for the first time since the Second World War, and a major war in Gaza with potential to escalate into a wider regional war. At the same time, autocratic nations are openly forming alliances, and democracies that we all took for granted are being challenged from within, nearly to breaking point.
The Federal Reserve’s April 2024 Financial Stability Report lists the worsening of geopolitical tensions as one of the main near-term threats to the financial system. It states that further escalation of geopolitical tensions could reduce economic activity, boost inflation, and heighten volatility. The report states that it may lead to a pullback from risk-taking, cause asset prices to decline, and result in trading losses for exposed businesses and investors.
Insurers are faced with the complex task of estimating the likelihood of further deterioration and the costs associated with this. Some key scenarios that insurers can consider include the following:
- War in Gaza escalates into a wider regional war
- Russia-Ukraine war escalates into a direct conflict with NATO
- Breakdown of US-China trade and diplomatic relations
- Invasion of Taiwan
- South China Sea territorial conflict
- US civil war
- Disorderly dissolution of the European Union
- Interference in US / Europe elections and civil unrest
- North and South Korean war
- Major cyber-attack and banking system failure
- Scenario 6: Two or more of the above scenarios occur simultaneously
The impact on the global economy from these scenarios may include:
- Disruption to oil supplies, global supply chains and energy markets
- Closure of shipping and air travel
- Major global economic slowdown, high market volatility, and disruption to capital markets
- Return of high inflation and upwards pressure on interest rates
Which in turn will impact the insurance industry leading to:
- Loss in business volume across all classes of business
- High claims frequency and high claims inflation
- High counterparty defaults, investment losses and operational losses
How insurers can make sense of this
A key first step to better understand and manage geopolitical risks is to undertake scenario analysis. The analysis will benefit from consulting with experts from outside of the insurance industry such as political analysts and security analysts.
Actuarial techniques can be used to convert the subjective estimates from these discussions into more holistic probability distributions and calculate a potential range for the losses under each scenario. The scenarios can also be combined, for example using a correlation matrix approach, to provide a view on the aggregate value at risk to the business.
Some key areas that will benefit from better quantification of geopolitical risk include the ORSA, business planning, reserving, pricing, capital modelling, exposure and aggregate management, model validation, reinsurance purchase and underwriting.
These results can also be used to assess whether the insurer’s Solvency Capital Requirement calculation remains appropriate in the current risk environment.
Bharat Raj, Head of London Markets at Broadstone’s Insurance, Regulatory and Risk division, said:
“The volatile geopolitical landscape at present is of huge global concern – especially the conflicts in Ukraine and the Middle East, which have been going on for a long period already. The potential deterioration between US and China relations also remains a significant risk.
“These are fast-moving situations with potential consequences that reach far beyond their borders and present a threat to economies across the world. Although direct losses from these events may be limited, for example through exclusions, insurers should not underestimate the potential knock-on impact on their businesses, which is likely to be material across all classes of business.
