COVID-19 has shown us how interdependent our supply chains and economies are, say David Maneval and John Lian – and risk managers need to take this lesson into other areas
COVID-19 has highlighted that supply chain and economic activities are highly interdependent, and that risk managers and regulators need to incorporate these interdependencies in their approach to risk management.
In mid-2021, the Monetary Authority of Singapore (MAS) directed insurers in the country to conduct a prospective stress test that included a base scenario and a macroeconomic scenario. The base scenario assumed a gradual recovery in global economic and trade activities, supported by successful COVID-19 vaccination programmes and continued accommodative policy responses from authorities throughout 2021–2023. It assumed modest economic growth.
The macroeconomic scenario (Figure 1), in contrast, assumed the emergence of vaccine-resistant virus strains, hampering global efforts to achieve herd immunity and fully reopen economies, and forcing the reimposition of mobility and border restrictions until new vaccines were developed and deployed. In this scenario, the world slips into a recession, with increased unemployment, corporate insolvencies and downsizing of businesses.
The macroeconomic scenario offers an opportunity for us to understand the interdependencies between supply chains, economic activities, investments, foreign exchange rates, liabilities and pandemics.
The investment parameters were specified by the MAS and applied cumulatively and sequentially as follows:
A. Change in equity prices1
B. Change in property prices1,2
C. Change in property rental prices1,2
D. Change in sovereign yield curves3
E. Change in credit spreads1
F. Change in exchange rates
G. Receive investment income4
1 Parameters provided by territory (by the MAS)
2 Parameters split between residential, industrial and commercial
3 Parameters specified by currency and tenure
4 For example securities and rental income
While the investment parameters were specified by the MAS, insurers were left to select non-investment parameters based on materiality and the nature of their business. A sample of potential considerations for general insurance is listed in Table 1.
The results of the MAS stress tests (which are not publicly available) show a drop in solvency and market value of assets for insurers in Singapore, while the market remains well capitalised and above minimum regulatory requirements.
In general, extreme scenarios can exhibit several types of interconnectedness, including:
- Dependencies between assets and liabilities
- Dependencies between economic sectors (which can lead to supply chain disruption)
- Cascading effects: dependencies between events from a single origin (for example the 2011 Tohoku earthquake causing a tsunami and a nuclear disaster)
- Accumulation of effects from events of separate origins (for example the simultaneous impact of COVID-19 and the Suez Canal blockage on the supply chain in 2021).
Climate change interdependencies
In the coming decades, global warming is expected to have a broad impact on our ecosystems and economies, with a multitude of interconnections and ramifications. Several regulators around the world are recognising the challenges and potential cascading effects associated with climate change, and are coming up with climate stress scenarios for banks and insurers.
The left portion of Figure 3 affects the liabilities of insurers as loss reserves could increase:
- Life, health, workers’ compensation: Increased spread of viruses and heat-related injuries
- Motor: Increased loss propensity arising from adverse weather conditions
- Property, engineering and business interruption: Increased frequency and severity of natural disasters
- Liability: Professional negligence in managing climate risk (once long-term climate-related damage materialises).
Insurers should also assess the impact of climate change on assets’ valuation and modify their investment mix to avoid depreciation or stranded assets.
A resilient node
The economy and communities are made up of nodes, whose interconnectedness increases with technology, communication and transportation. As a node is damaged, insurance often helps heal that section of the ‘web’. As a node itself, however, insurance needs to be resilient to, and recognise, major dependencies in the network to best capture opportunities and promote a healthy network.
David Maneval is head of analytics for Asia at Lockton, Singapore
John Lian is a retrocession broker at Gallagher Re, Singapore